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Tick, tick, tick ... FINRA rewrites 'culture,' 'conflicts of interest' and 'ethics' into a farcical 'best interests' code after DOL drops a bomb on its suitability ethos

In its latest burst of bureaucratic creativity, the wirehouse cop acknowledges the scourge of Wall Street culture then quickly excuses the behavior it elicits

Friday, January 29, 2016 – 6:33 PM by Guest Columnist Ron Rhoades
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Richard Ketchum professed support for a fiduciary standard,then, in the same speech, opposed the DOL's proposed rule-making, calling it 'problematic.'

Brooke’s Note: In the Oxford Handbook of Financial Regulation there is a passage about the “rationale” of having a self-regulatory organization policing its own band of thieves. The Oxford writer says the thinking goes that the industry knows better where the bodies are buried and where regulation is helpful or overbearing — as opposed to a bunch of government bureaucrats. He goes on to write that in the case of FINRA, the SEC is the “shotgun behind the door” that gives buckshot to what FINRA is doing. The SRO rationale does, by the most glancing measure, have many of the elements of what you might term a hare-brained scheme — shotguns and all. But on top of its quasi-incomprehensible rationale is what appears to be FINRA’s very profound innovator’s dilemma: To change its ways to a 2016 model, never mind 2025, it would need to regulate more in the way the SEC polices RIAs — a method that seeks to engender the right “spirit.” But the scale and structure of wirehouse brokerage houses makes any innovation a matter of existential threat — making it a threat to its private police force. Those institutions overseen by FINRA are challenged in culture, ethics and other elements of the fiduciary spirit. With DOL forcing FINRA’s hand toward innovation, it’s had to make moves. What Ron Rhoades does here in examining those moves is lay bare exactly what is going on. You may agree or disagree about whether FINRA is the right regulator but whether or not FINRA, with all its perambulations, is evolving, or innovating, leaves far less room for disagreement after reading this two-part piece.

“I am a stock and bond broker. It is true that my family was somewhat disappointed in my choice of profession.” — Binx Bolling, The Moviegoer (1960)

FINRA recently advanced a “best interests” standard — raising industry hopes that the organization had finally given ground in the cause of enforcing principled care of financial advisory clients in the wake of the Department of Labor’s crackdown on loose readings of what it means to be a fiduciary. See: Snakes and ladders: What to expect in the unexpectedly triumphant final DOL fiduciary rule.

The positive signals sent by the Financial Industry Regulatory Authority Inc., the stock brokerage-owned regulator of stock brokers, came in its institutional utterance of words that are de facto expletives in polite Wall Street society.

Those words include “culture,” “conflicts of interest” and “ethics” — three areas where Wall Street has proven incorrigible due to its reliance on delivering financial advice in the form of conflict-ridden product sales.

Yet a closer look reveals that the introduction of these inconvenient words into discourse are FINRA feints — helped along by brokerage lobbying organization SIFMA — intended solely to distract from the perpetuation of a decades-long deception. It includes a rewrite of a centuries-old, strict, legal standard to a new suitability regime, together with casual disclosure of conflicts of interest combined with securing the customer’s uninformed consent.

The end effect is the status quo.

In recasting its standards, FINRA unleashes refreshed obfuscation aimed at confusing investors even more than they had been before. See: Weighed down by nonstop fines, LPL finally buys ounce of prevention by putting ex-FINRA veterans on its payroll.

In touting a new “best interests” standard that, as will be shown, falls far short of a true fiduciary standard of conduct, FINRA perpetuates a 75-year history of opposing the substantial raising of standards of conduct for brokerage firms and their registered representatives. In so doing, FINRA continues its long-standing failure to live up to the hopes of Sen. Francis T. Maloney, who once stated that his Maloney Act of 1938 (which led to the establishment of NASD, now known as FINRA) had, as its purpose, “the promotion of truly professional standards of character and competence.” See: FINRA’s scandalous litany of failures and its efforts to redefine the true fiduciary standard out of existence.

The compelling solution for these decades-long failures is to disband FINRA.

It’s a measure that sounds drastic until one considers that this organization — whose original purpose was to make brokers exercise transparency and care in delivering financial advice — has done the exact opposite. Instead, it has institutionalized the practice of receipt of multiple revenue streams to brokers from the sale of a product, seemingly excused by fine-print paragraphs that fail to quantify the harm caused by this excessive rent extraction.

Ketchum’s idea of 'best interests’

Exhibit A of this schizophrenia was on full display on May 27, 2015 when FINRA chairman and CEO Richard Ketchum addressed broker-dealer firm executives gathered at the 2015 FINRA Annual Conference.

There, he disarmingly inquired of brokers whether “the time has come to require broker-dealers, when recommending a security or strategy to retail investors, to ensure that the recommendation is in the 'best interest’ of the investor.”

Ketchum went on to equate the “best interests” standard with the “fiduciary standard,” noting that the standard has existed under the law for centuries. Ketchum then outlined what a “best interests” standard for brokers would look like, based upon the principles involving “consent” by the customer to conflicts of interest, procedures to “manage” conflicts of interest, “more effective disclosure” to customers, and that firms undertake “fee leveling” for registered representatives.

Ron Rhoades:  We must acknowledge that, if disclosures were effective, fiduciary law would not exist.
Ron Rhoades: We must acknowledge
that, if disclosures were effective, fiduciary
law would not exist.

Yet, despite Ketchum’s apparent support for a fiduciary standard, in the same speech he opposed the U.S. Department of Labor’s proposed rule-making, calling it “problematic” with the necessity of “contractual interpretations” by jurists and further questioning “how a judicial arbiter would analyze whether a recommendation was in the best interests of the customer 'without regard to the financial or other interests’ of the service provider.” The White House puts its best Obamacare minds behind cleaning up the 401(k) business — starting by issuing a withering memo

Unfathomable objection

FINRA’s objections appear to this observer to be nonsensical, in light of history. The fiduciary duty of loyalty, often referred to as requiring the advisor to act in the “best interests” of a client, has — as Ketchum stated — been applied in various legal contexts for hundreds of years. Moreover, judges and arbitrators have, for centuries, interpreted contracts.

Moreover, the additional DOL requirement that FINRA unfathomably objects to, that firms and advisors act “without regard to the financial or other interests” of the service provider, is derived from Section 913 of the Dodd-Frank Act. It is the language that must be applied by the SEC, if and when the SEC moves to adopt a fiduciary standard for brokers.

Moreover, in the eyes of this observer, this additional language much more clearly establishes a clear test for judicial finders of fact than the vague suitability standards, and this language provides concrete guidance for both brokers and their registered representatives.

Does FINRA seek to address a brokerage firm’s 'culture’ and 'ethics’?

In FINRA’s 2016 Regulatory and Examination Priorities Letter, promulgated on Jan. 5, FINRA also sought to address three broad issues of “culture” and “conflicts of interest” and “ethics.”

With regard to “culture,” FINRA referred “to the set of explicit and implicit norms, practices, and expected behaviors that influence how firm executives, supervisors and employees make and implement decisions in the course of conducting a firm’s business.”

Yet, while FINRA noted that a brokerage firm’s “culture has a profound influence on how a firm conducts its business and manages its conflicts of interest,” FINRA also stated that it “does not seek to dictate firm culture.” See: Stockbrokers are ready to shed their sales culture, says SEI Investments study.

As to conflicts of interest, FINRA appears to take an approach similar to the U.S. Department of Labor’s proposed “Best Interests Contract Exemption” to its proposed “conflicts of interest” rule.

FINRA states that its targeted examinations of brokerage firms “encompasses firms’ conflict mitigation processes regarding compensation plans for registered representatives, and firms’ approaches to mitigating conflicts of interest that arise through the sale of proprietary or affiliated products, or products for which a firm receives third-party payments (e.g., revenue sharing).”

Likewise, DOL’s proposed BICE prohibits differential compensation to individual registered representatives (while still permitting same to the brokerage firm itself, subject to certain restrictions), and sets standards before proprietary products can be recommended to customers.

As to “ethics,” while FINRA stated that it was a broad area of focus, not surprisingly there is little discussion in FINRA’s letter that directly addresses a broker-dealer firm’s code of ethics. See: Can advisors keep their dirty compliance laundry in the closet thanks to lack of NASAA, SEC and FINRA coordination?.

Does FINRA already possess a 'best interests’ standard?

In Ketchum’s 2015 remarks, he speaks of brokers moving toward a “best interests” standard. Yet, in widely criticized earlier 2011 and 2012 releases, FINRA already opined that a “best interests” standard exists for brokers.

In 2012 guidance to brokers regarding FINRA Rule 2111 (“Suitability”), FINRA previously stated that:

“In interpreting FINRA’s suitability rule, numerous cases explicitly state that 'a broker’s recommendations must be consistent with his customers’ best interests.’”

FINRA’s statement was largely seen as a movement toward a fiduciary standard, as found under the Investment Advisors Act of 1940.

FINRA’s true intentions revealed

In its July 17, 2015 comment letter to the U.S. Department of Labor, FINRA revealed the ugly truth that it’s interpretation of “best interests” falls far below that required by a bona fide fiduciary duty of loyalty. FINRA stated:

“FINRA has publicly advocated for a fiduciary duty for years and agrees with the Department that all financial intermediaries, including broker-dealers, should be subject to a fiduciary “best interest” standard … At a minimum, any best interest standard for intermediaries should meet the following criteria … The standard should require financial institutions and their advisors to:

• act in their customers’ best interest;

• adopt procedures reasonably designed to detect potential conflicts;

• eliminate those conflicts of interest whenever possible;

• adopt written supervisory procedures reasonably designed to ensure that any remaining conflicts, such as differential compensation, do not encourage financial advisors to provide any service or recommend any product that is not in the customer’s best interest;

• obtain retail customer consent to any conflict of interest related to recommendations or services provided; and

• provide retail customers with disclosure in plain English concerning recommendations and services provided, the products offered and all related fees and expenses.”

These criteria closely follow upon SIFMA’s more detailed proposal for a new “best interests” standard that would modify FINRA’s suitability rule. As will be discussed below, the requirements of FINRA’s suggested “best interests” standard do not impose a bona fide fiduciary duty of loyalty upon brokers. See: New York conference: SIFMA wants members to be like RIAs — minus the same rules of accountability.

Additionally, FINRA suggests to the DOL that it offer “offer financial institutions a choice: either adopt stringent procedures that address the conflicts of interest arising from differential compensation, or pay only neutral compensation to advisors.”

How about third-best?

Yet, the adoption of “stringent procedures” is not the adoption of a fiduciary standard of conduct. Nor does the payment of neutral compensation to advisors prohibit the broker-dealer firm, itself, from the receipt of additional compensation as they promote the sale of products that would pay them more. Also, the receipt of additional compensation by the broker-dealer firm would not adhere to the DOL proposed rule’s requirement that product recommendations be undertaken without regard to the financial or other interests of the financial institution. See: Why exactly DOL’s latest action is so shocking to so many brokers — and even ERISA lawyers — despite years of warnings.

FINRA also suggests to the DOL that it, in essence, lower the fiduciary duty of due care. FINRA states, incorrectly, that: “Fiduciaries generally are not required to discern or recommend the 'best’ product among all available for sale nationwide or worldwide. Investment advisors, for example, are required to recommend suitable investments, not the 'best’ investment available to the customer. A requirement to recommend the 'best’ product would impose unnecessary and untenable litigation risks on fiduciaries.”

Yet, fiduciaries, in adherence to their fiduciary duty of due care, and judged against other prudent experts, clearly possess the obligation to undertake extensive due diligence. This due diligence requires fiduciaries to select the best investments resulting from the fiduciary’s due diligence processes, augmented with the exercise of good judgment during the due diligence process. See: Op-Ed: The fiduciary standard is in worse shape than it was four years ago.

Think about it. A fiduciary also possesses a fiduciary duty of utmost good faith, which includes as part thereof a duty to the client of honesty and complete candor. Would, in observance of this duty, a fiduciary ever go to a client and state: “Our due diligence has indicated that this is the third-best mutual fund on the marketplace today within this asset class. But, even though other two other products would be better for you, we don’t recommend them.” Of course not. See: An X-ray of one affluent, educated and sophisticated investor’s portfolio shows how it was chewed up by fees.

While fiduciary advisors certainly, in their exercise of good judgment, might disagree about what product is “best,” once a fiduciary advisor determines through a properly applied due diligence process the “best” investment product to meet the client’s specific needs, then the fiduciary has the obligation to recommend that product to the client.

I am not suggesting that all fiduciaries would reach the same conclusion, as to the choice of either investment strategy or investment products. But a due diligence process, using sound criteria, and applying good judgment, will result in a “best product” to be discerned by that advisor, and the fiduciary advisor would clearly be unwise if such product were not recommended.

What FINRA really wants the broker to be able to do, by its comment, is to continue to recommend virtually any product, under the failed suitability standard, even when that product is nowhere close to being the best product in the marketplace.

Failed suitability standard

Even though FINRA in its June 17, 2015 comment letter criticizes the DOL for introducing “new concepts that are fraught with ambiguity,” the reality is that FINRA is the promulgator of ambiguous and often contradictory rules and statements with regard to the standards governing brokers. See: Analysis: Beware of a FINRA bearing gifts for RIAs.

In fact, it is FINRA’s suitability standard that is both ambiguous and often arbitrarily applied. In the early 20th century, FINRA’s suitability standard was originally designed to mitigate the duty of due care that all service providers possess, in recognition that a broker should not be liable for the default of a security merely for performing “trade execution” services.

Inexplicably, however, the suitability standard was expanded in the 1970’s to brokers’ recommendations of investment managers (including mutual fund providers). In turn this has led to a wide plethora of pooled investment vehicles, often expensive, and often with “hidden” revenue-sharing. The result has been widespread harm to investors, given the substantial academic research demonstrating the close relationship between high mutual fund fees and costs and lower returns, on average. Moreover, individual Americans are unable to recover from brokers due to a breach of the duty of due care, since brokers do not possess such a duty — even thought nearly every other service provider in the United States possesses such a duty.

Instead, investors are left, under suitability, with a subjective, unclear, amorphous legal standard. Even worse, the suitability standard is applied in FINRA arbitration, not as a strict legal standard, but rather under an approach of “equitable fairness” — leading to an inefficient and confused application of the law by arbitrators with no duty to record their reasoning, and from which arbitration there are very limited rights of appeal. See: The suitability standard, defined.

Suitability does not generally require registered representatives to recommend a lower cost product with similar risk and return characteristics, if one is available. Nor does the suitability doctrine require monitoring of an investment portfolio (even where ongoing fees are received by the brokerage firm). Nor does suitability require the design and management of the investment portfolio for a client in a tax-efficient manner. See: How RIAs can help clients sell their real estate without taking a tax bite.

Confusing, contradictory statements

FINRA’s statements over the past few years have often been contradictory. FINRA stated to brokers in its earlier release regarding Rule 2111 that brokers’ recommendations must be consistent with the “best interests” of their customers. Yet, just last year, FINRA stated to the U.S. Department of Labor: “We recognize that imposing a best interest standard requires rulemaking beyond what is presently in place for broker-dealers.” [Emphasis added.]

In 2005, FINRA opposed the application of the Advisors Act’s fiduciary duties upon brokers who provided fee-based accounts, even though FINRA acknowledged that, “[f]rom a retail client’s perspective, the differences between investment advisory services and traditional brokerage services are almost imperceptible.” Stating that “brokerage investors are fully protected” FINRA even questioned the need for additional disclosures to investors.

In a widely criticized statement, FINRA also expressed in 2005 that the SEC’s proposed disclosure for fee-based accounts “implies that customer’s rights, the firm’s duties and obligations, and the applicable fiduciary obligations are greater with respect to an investment advisor account than they are with respect to a brokerage account.

As we have previously discussed, this is simply not the case. FINRA’s statement is clearly erroneous, as everyone and their mother agree that the fiduciary standard is a higher standard than the suitability standard. FINRA’s statement is also contradictory to the FINRA Chair’s recent comments in which he suggests that brokers move toward a higher “best interests” standard.

Best interests = Fiduciary duty of loyalty

While Adam Smith saw virtue in competition, he also recognized the dangers of the abuse of economic power in his warnings about combinations of merchants and large mercantilist corporations.
While Adam Smith saw virtue in
competition, he also recognized the dangers
of the abuse of economic power
in his warnings about combinations of
merchants and large mercantilist corporations.

In a Dec. 2, 2015 hearing before the Subcommittee On Health, Employment, Labor, And Pensions, of the U.S. House Education and Workforce Committee, Jules O. Gaudreau Jr., ChFC, CIC testified, on behalf of the National Association of Insurance and Financial Advisors, under oath: “We already believe that we do engage in the best interests of our clients; we take an ethics pledge on their behalf.”

Subsequently, U.S. Rep. Suzanne Bonomaci addressed testimony in an earlier hearing, noting that securities industry executives all responded affirmatively when she inquired, “Just to be clear, does everyone agree that a 'best interests’ standard means a 'best interests’ fiduciary standard?”

Yet, Gaudreau later testified, “These decisions that consumers make in the financial realm are based upon rapport and trust and relationships. These are not just simple transactions … we don’t disagree that we should work in the best interests of our clients; my family’s been doing that for a hundred years. In fact, it’s a little insulting to imply that we ever haven’t. The fact is that we absolutely agree with that and endorse that public policy.”

“Should retirement advisors be able to place their own profit-seeking before the best interests of their clients?” asked U.S. Rep. Ellison at the Sept. 10, 2015 Congressional Joint Hearing before the Subcommittees on Oversight and Investigations and Capital Markets and Government Sponsored Enterprises, of the House Financial Services Committee, entitled “Preserving Retirement Security and Investment Choices for All Americans.”

The president of NAIFA replied: “No.” Immediately thereafter all of the panelists, most of whom represented the securities industry, agreed that they were for the “best interests” standard.

This begs the question … if insurance companies and broker-dealers say that they support acting in the “best interests” of their customers, do they truly understand the fiduciary duty of loyalty? Or, are the executives’ understandings of the term “best interests” flat out disconnected from the understanding of that legal term under fiduciary law, and as commonly understood by the vast majority of Americans?

Half-truths and deceptions

“Goldman’s arguments in this respect are Orwellian. Words such as 'honesty,’ 'integrity,’ and 'fair dealing’ apparently [in Goldman’s eyes] do not mean what they say; [Goldman says] they do not set standards; they are mere shibboleths. If Goldman’s claim of 'honesty’ and 'integrity’ are simply puffery, the world of finance may be in more trouble than we recognize.” — Judge Paul Crotty, Richman v. Goldman Sachs Group, Inc., 868 F. Supp. 2d 261 (S.D.N.Y. 2012).

When we are dealing with the fiduciary standard of conduct, and its requirement that the fiduciary act in the “best interests” of the entrustor (client), we should not accept half-truths and deception. If the fiduciary standard is to possess meaning, we must hold firms and persons accountable to their words, and not regard these important words as mere “puffery.”

As stated by Professors James Angel and Douglas McCabe: “Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise — to give biased advice with the aura of advice in the customer’s best interest — is fraud.”

We know that disclosures are ineffective

Academic researchers have long known that emotional biases limit consumers’ ability to close the substantial knowledge gap between advisors and their clients. Insights from behavioral science further call into substantial doubt some cherished pro-regulatory strategies, including the view that if regulators force delivery of better disclosures and transparency to investors that this information can be used effectively. This is in large part due to many behavioral biases that limit the effectiveness of any form of disclosure.

Note as well that, as Prof. Robert Prentice has written, “instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.”

Moreover, as observed by Professors Stephen J. Choi and A.C. Pritchard, “not only can marketers who are familiar with behavioral research manipulate consumers by taking advantage of weaknesses in human cognition, but … competitive pressures almost guarantee that they will do so.”

As a result, much of the training of registered representatives involves how to establish a relationship of trust and confidence with the client. Once a relationship of trust is formed, customers will generally accede to the recommendations made by the registered representative, even when that recommendation is adverse to the customers’ best interests.

The SEC’s emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities Acts on enhanced disclosures, results from the myth that investors carefully peruse the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image of a vast majority of investors who are unable, due to behavioral biases and lack of knowledge of our complicated financial markets, to comprehend the disclosures provided, yet alone undertake sound investment decision-making. See: How suitable are your investment strategies? The SEC cares, a lot..

As stated by Professor (now SEC Commissioner) Troy A. Parades: “The federal securities laws generally assume that investors and other capital market participants are perfectly rational, from which it follows that more disclosure is always better than less. However, investors are not perfectly rational. Herbert Simon was among the first to point out that people are boundedly rational, and numerous studies have since supported Simon’s claim. Simon recognized that people have limited cognitive abilities to process information. As a result, people tend to economize on cognitive effort when making decisions by adopting heuristics that simplify complicated tasks. In Simon’s terms, when faced with complicated tasks, people tend to 'satisfice’ rather than 'optimize,’ and might fail to search and process certain information.” See: Groundbreaking SEC study would smash old regulatory system, creating fiduciary brokers and more regulated advisors.

Other investor biases overwhelm the effectiveness of disclosures. As stated by Professor Fisch: “The primary difficulty with disclosure as a regulatory response is that there is limited evidence that disclosure is effective in overcoming investor biases. ... It is unclear … that intermediaries offer meaningful investor protection. Rather, there is continued evidence that broker-dealers, mutual fund operators, and the like are ineffective gatekeepers. Understanding the agency costs and other issues associated with investing through an intermediary may be more complex than investing directly in equities ….”

The truth about disclosures

The inadequacy of disclosures was known even in 1930’s.

Even back during the consideration of the initial federal securities laws, the perception existed that disclosures would prove to be inadequate as a means of investor protection.

As stated by Professor Schwartz: “Analysis of the tension between investor understanding and complexity remains scant. During the debate over the original enactment of the federal securities laws, Congress did not focus on the ability of investors to understand disclosure of complex transactions. Although scholars assumed that ordinary investors would not have that ability, they anticipated that sophisticated market intermediaries — such as brokers, bankers, investment advisors, publishers of investment advisory literature, and even lawyers – would help filter the information down to investors.”

We must acknowledge that, if disclosures were effective, fiduciary law would not exist. There would be no fiduciary duties imposed upon trustees, or attorneys, or others in a relationship of trust and confidence with their entrustor in which a substantial difference in either power or knowledge exists. Fiduciary duties are imposed because disclosures are effective.

Click here for part 2 of Rhoades’ report.

Stephen Winks

Stephen Winks

January 29, 2016 — 11:40 PM

Ron Rhoades accomplishes what the investing public expects FINRA to do, to clarify and authenticate the role and responsibilities of the broker when rendering advice. There is little opportunity for disagreement with his expert assessment, leaving the question of whether FINRA is acting as an advocate for brokerage industry interests rather than the best interest of the investing public. It is clear to all, to include FINRA itself, that FINRA’s policies concerning fiduciary duty deny “retail investors” who need the most help, the same consumer protections accorded to all other investors. Mr. Ketchum might want to explain why there is any difference between the best interest of retail investors and other investors. Ron Rhoades has made a compelling and definitive case for the “client’s best interest and the fiduciary duty required of all who render advice. Mr. Ketchum is terribly unconvincing in making FINRA’s case which undermines public trust and suggests a rigging of industry regulation not in accord with century’s of common law understanding of fiduciary duty..
Stephen Winks



August 17, 2016 — 11:55 PM

I do not have any significant issues with what is presented. But the one thing that suitability or fiduciary duty requires is knowledge. Having taught almost all the securities, insurance et al courses, the fundamentals of investing have never been taught to brokers or registered investment adviser. They are not tested- hence not required. FINRA, the SEC, NASSA and more have a monstrous effort ahead of them in order to do the right thing. Per Schwartz- “Although scholars assumed that ordinary investors would not have that ability, they anticipated that sophisticated market intermediaries — such as brokers, bankers, investment advisors, publishers of investment advisory literature, and even lawyers – would help filter the information down to investors.” After decades in this business, I just don’t think it will happen. The UPIA is way out of date and the DOL ruling cannot work in real life. http://efmoody.com/DOL%20ruling%206.5.2016.pdf

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