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Construction : Cover Story | December 2015 | Source : Infrastructure Today

Hit by the HAMmer

Beset with various issues, the hybrid annuity model (HAM) faces challenges related to bankability and implementation.

The Hybrid Annuity Model (HAM) unveiled with great fanfare earlier this year was expected to set off the next wave of award of PPP highway projects. The intent and purpose of introducing HAM, as a hybrid of EPC and BOT (annuity) formats, was noble and deserves to be lauded: to moderate risks faced by highway developers and to provide financial support during construction. To this end, Ministry of Roads Transport & Highways (MoRTH) formulated and released a Model Concession Agreement (MCA) for HAM (HAM Agreement). This was to set the context and framework for engagement between the National Highways Authority of India (Authority) and the concessionaire, on lines similar to the MCA for BOT (toll or annuity) formats.

The HAM Agreement has been reviewed by various stakeholders after its release and several issues have been raised. Unless these are resolved, the expected awarding of projects is unlikely to take off. Several key provisions need serious overhauling, or even need to be junked and re-written altogether.

The Good, the Bad and the Ugly
The HAM Agreement starts off on a good note.
In fact, several early Articles pertaining to Conditions Precedent regarding provision of site to the concessionaire indicate vast improvements over corresponding provisions in the MCA, addressing allocation of risks pertaining to one of the most prominent factors in determining the successful outcome of the project in an equitable manner. The most notable are the additions of clauses (10.3.7) expressly stating that ô80 per cent of Site shall mean and imply land that shall enable the Concessionaire to undertake construction on at least 80 per cent of the length of the Project´ and addition to Cl. 10.3.4, limiting scope of project to land acquired by Authority till 180 days from the appointed date.

After a decent beginning, the HAM Agreement then unnecessarily deviates from MCA provisions at places and imposes additional obligations and costs on the concessionaire, which, rightfully, must be borne by Authority. For example, maintenance of existing road during the development period and requirement to bear costs and expense of felling of trees are now imposed on the concessionaire. Time-lines for Authority to fulfil its Conditions Precedent are extended by 90 days, making the total time period 240 days, i.e. almost eight months from signing of agreement. In contrast, time-line for the concessionaire to achieve financial closure is reduced from 180 days to 150 days, creating an imbalance between time-lines for Authority and concessionaire to fulfil their Conditions Precedent and achieve Appointed Date without incurring any damages.

Where the HAM Agreement really fails is in ensuring a clear and unwavering definition of the revenue stream for the project (Article 23). The revenue stream, as would be considered by concessionaire in the financial model, is subject to too many potential adjustments along the way, both during construction and O&M periods. These are not commercial risks, as in the case of toll projects, which the concessionaire is expected to assess and bear, but risks emanating from unforeseeable events, the determination of impact of which, under the provisions of Article 23, is largely left to the discretion of Authority and Independent Engineer (IE). In some instances, there is also a lack of clarity in the language of provisions of Article 23, with potential for differing interpretations by Authority and concessionaire. These concerns affect the sanctity of the revenue stream and destroy the element of certainty normally expected and associated with an annuity model.

Another major area of concern, in deviation from provisions of MCA, is that the Termination Payments for Force Majeure or Default Events do not adequately cover substantial portions of equity and debt deployed by concessionaire on the project, and thus offer poor protection to it and to the lenders to the project. MCA itself was found wanting in provisions related to Termination Payments, but the HAM Agreement makes it worse.

Uncertainty in revenue stream and termination payments would require a complex regime of sponsor support to be provided by concessionaire in order to achieve financial closure for the project. This would be an unrealistic and near-impossible proposition for the concessionaire to meet. The HAM Agreement, therefore, suffers from serious issues that mar its bankability.

Shaky top-line
Article 23 (Payment of Bid Project Cost) determines the revenue profile of the project in a manner distinct from MCA (toll or annuity), and is the engine driving the HAM Agreement. Unfortunately, it comes embellished with so many bells and whistles that it has been rendered unwieldy and unworkable. HAM is predicated upon the fact that the concessionaire has to tie up only 60 per cent of project cost through equity and debt, and balance 40 per cent shall be received during construction period. However, the receipt of this 40 per cent is subject to achieving physical progress milestones, determination of which is to be carried out and certified by IE. To start with, physical progress is a vaguely defined term, and bestows discretionary powers to IE. Physical progress milestone payment does not comprehensively cover the preliminary and pre-operative expenditures incurred by concessionaire, including interest during construction, which are substantial and front-ended and which also need to be paid for.

Worse still, there are no time-lines specified for IE to certify the achievement of physical progress milestones. The concessionaire would therefore be at the mercy of IE five times during the construction period to obtain the 40 per cent payment instalments. This does not bode well. Industry experience on IE´s independence is not encouraging, to put it very mildly.

Also, given the penchant of Authority to issue extraneous circulars and insist on the concessionaire to sign supplementary agreements, concessionaire would be subject to such pressures five times during construction period, requiring it to waive off shortcomings in Authority´s fulfilment of its obligations, especially related to land and clearances, in order to secure cash-flow for execution. This would be detrimental to the risk-sharing envisaged for PPP projects and all risks under the Concession would willy-nilly get passed on to the Concessionaire. In case there is a change in scope during construction, the determination of physical progress is further muddled as it has to take into account impact of such change of scope.

Determination of cost and time impact of change of scope is notoriously time consuming and uncertain. In case payments are held up on this account, it would adversely impact the progress of the project. Annuity payments during the operation period are fraught with similar serious issues too. The payment schedule, in terms of percentage of completion cost is progressively increasing and back-ended. It starts with 2.1 per cent for 1st annuity and increases respectively to 2.76 per cent for 10th annuity, 3.72 per cent for 20th annuity and 4.75 per cent for 30th annuity. The last five annuities (26th to 30th) account for 23 per cent of completion cost, i.e. 38 per cent of the total 60 per cent operation period pay out.

Presumably, this is done to mirror the typical repayment schedule of the principal amount of debt. In doing so, it rigidly dictates the schedule of repayment of principal of debt and is a case of Authority micromanaging the terms of debt funding. Severely back-ended repayment of principal would increase the interest outgo for the project, and would also impact the viability and attractiveness of the project. Interest on reducing balance of completion cost at applicable bank rate +3 per cent is payable along with each annuity payment. This does not really take away the interest risk entirely in case the concessionaire raises debt at a higher rate.

In case the concessionaire is able to raise debt at a lower cost, would the Authority guarantee to pay at stated rate of bank rate +3 per cent? Is it also the intention of the Authority to pay interest on cost that is part funded by equity? These questions are not without basis. Dig deeper into Article 31 (´Termination´) and the Termination Payment under pre- and post- COD scenarios account for the 40:60 bifurcation of Bid Project Cost and also factor in a 75:25 debt-equity ratio. The apprehension is that while the revenue stream in the financial model of the concessionaire would be based on the express provisions of Article 23, Authority would very likely have spotted these inconsistencies, perhaps justifiably so, by the time release of payments is due. The Authority would then, mindful of watchdog agencies, balk at releasing the payments as expressly stated In the HAM Agreement. This would not only render a body blow to the project financials but also lead to serious disputes and several heartburns. It is desirable to address these issues head-on today and tackle them, rather than shove them under the carpet now and rue later. There are several other flaws in the provisions of Article 23 and few other Articles (change of scope, force majeure and termination). But with so many critical issues rendering the quantum and timing of the revenue stream unreliable, Article 23, as it presently stands, needs to be scrapped and re-written altogether again.

Helping hand, but with a tight grip
The purpose of a model Agreement is that, once the fundamental obligations and performance-based parameters are defined, the project must proceed unhindered and without any intervention by the Authority, which must conduct itself purely as a party to a commercial contract. In the absence of a separate sector-specific regulatory body, this is not entirely the case as the Authority dons the role of regulator itself to some degree. Therefore, it is all the more important that its intervention under the provisions of the model Agreement is kept to the bare minimum.

This also ensures uniformity across projects of varying nature and eliminates or vastly reduces scope for discretion by any one party. The HAM Agreement in contrast, in its zeal to hand-hold the concessionaire every step of the way, has accorded a big-brother role to the Authority, and to a great extent, also to the IE. The genesis of formulating these ´micromanaging´ provisions lies in the urge to rein in the ´irresponsible behaviour´ that the concessionaires seemingly indulged in under the MCA, which supposedly resulted in unrealistic bids, stalled execution and financial mismanagement of projects.

The fact of the matter is that to some extent, the developer community has brought this down upon itself. But in trying to correct the situation, the HAM Agreement has accorded a presumptuous role to the Authority vis-a-vis the concessionaire and has made the concessionaire dependent on the discretion of the IE and Authority at almost every step of executing the project. Such discretionary powers would result in personality- and circumstance-driven decisions and result in non-uniform treatment across projects, thereby nullifying the very essence of having a ´model´ Agreement. This aspect needs to be addressed seriously.

Several formulations in HAM Agreement, especially related to O&M and impact of COS, assume that all highway projects are alike, made of homogeneous stretches along their lengths and are neatly and uniformly measurable. In reality, highway projects are messy, vary across geographies, and vastly affected by physical features of terrain, soil conditions and social settings, and cannot be measured by a simple ruler. The model Agreement must not be so overly simplistic, that in fact it loses on the flexibility to be equally relevant in different situations.

The most fundamental, and perhaps existential, question regarding HAM in its present form though, is this: with only 60 per cent of cost tied up ab initio (please note: Termination Payment secure amounts which are calculated based on 60 per cent Bid Project Cost only), with recovery of balance 40 per cent cost based on revenue inflows which are fraught with uncertainties, can the project which has raised funding under the HAM Agreement be considered to have achieved financial closure? The above issues and several others put a big question mark on the bankability of the HAM Agreement. The only way to fix it really is to go back to the drawing board all over again.

A simple fix is possible
Notwithstanding the complexity of the problem with HAM Agreement as outlined above, it is really possible to fix it quite simply and easily. To start with, it is essential to put maturity back in the relationship between the Authority and Concessionaire and to curtail the various interventions of Authority and IE once the concession has commenced. Notwithstanding previous experience on PPP projects, responsibility of financial management must rest squarely with concessionaire and lenders to the project, and not micromanaged by Authority. That is the only proper way of ensuring a meaningful partnership. The following specific broad measures are suggested to fix the HAM Agreement and make it bankable and workable:
i.Financial close must be defined as commitment by concessionaire to fund the entire capital cost through equity and debt. The upfront equity contribution by concessionaire must be allowed to be low. Progress milestone payments (cumulatively 40 per cent of bid project cost) once received must correspondingly be applied to reduce the debt and equity obligations as per debt:equity ratio in the financial model of the concessionaire. In the event the progress milestone payments are delayed or stuck in dispute, however, the concessionaire and lenders must be committed and be able to bring in the entire debt and equity required to progress the project, barring a termination event. Delayed receipt of progress milestone payments must be allowed to be adjusted against subsequent debt and equity requirements.

Any surplus debt and equity infused by concessionaire to bridge the delay in progress milestone payments may be allowed to be recovered from such payments no later than date of commissioning of the project.

ii.Progress milestones must be de-linked from physical progress to remove discretionary intervention by IE and Authority, and to be determined by financial progress of the project. This would also enable all development costs, besides physical progress costs, to be comprehensively accounted for. In order to ensure that the reported financial progress does not run way ahead of physical progress, as has been the case in some instances in the past, a concept from a recently issued Order by MORTH may be borrowed and improvised upon. (The Order also contains an element of measurement of physical progress by IE which complicates the matter and therefore this element needs to be discarded). It may be provided that the financial progress reported shall not include advances of any kind to any person or expenditure of any kind on plant and machinery of more than 10 per cent of the total capital cost.
iii.Payment of 60 per cent of bid project cost during O&M period must be through equal semi-annual payments.
iv.Concessionaire to provide for all costs in determination of the bid project cost, which shall be the bid parameter.
v.There shall be no separate payments for interest and O&M costs by Authority.
vi.Impact of change in scope, including reduction in scope, must be on a one-time determination basis and must not cause adjustments to the revenue stream of the project.
vii.Termination payments, as a principle, must be calculated with 100 per cent project cost as a basis, with adjustments made for progress payment already made to the concessionaire. This would provide security to cover the funding for entire project cost and improve bankability.
viii. Other provisions must be suitably modified to address the issues outlined herein, and the improvements in HAM Agreement over the MCA must be retained and enhanced.

This article has been authored by Sanjay Date, an infrastructure development professional based in Mumbai. Views expressed in this article are personal. Reader feedback is welcome at


Table-1: THE GOOD

1 No payment of Damages by either Party for non-fulfilment of CPs till other Party has fulfilled its CPs. 4.2 & 4.3 New Addition - equitable treatment.
2 Commencement of Concession Period on Financial Close and completion of CPs; to be conveyed by notice by Concessionaire to Authority. 4.4 New Addition: removes ambiguity around occurrence of Appointed Date.
3 Termination in case Appointed Date does not occur within 1 (one) year. 4.5 New Addition: Definitive outer timeline for project to start -safeguards against projects from "languishing". However, a provision may be added that in case of non-occurrence of Appointed Date for reasons attributable to Authority, it shall pay an amount equal to Bid Security to Concessionaire toward bid and Conditions Precedent compliance costs.
4 Earlier provision for waiver by Authority on Concessionaire request for any
Condition Precedent at its discretion.
4.1.3 in MCA - not mentioned in HAM Agreement. None of the conditions could have been waived by Authority discretion. Ambiguity removed.
5 Both Authority and lenders given step in rights with the proviso that in case both Authority and lenders exercise their rights to step in, Authority shall have sole right to step in. 5.2.4 Step in rights of lenders clearly defined to remove ambiguity and order of priority is also clarified.
6 Authority to bear R&R costs of project affected people and provide reasonable support to Concessionaire to obtain approvals (other than GADs for ROB/RUB, which are Authority CPs). 6.1 (j) & (k) New Additions: Proper allocation of risk and responsibility. Opening square bracket "[" to indicate optional part maybe moved before "other than approval..." It may be clarified that approval of GAD for ROB / RUB, if any, is Condition Precedent to be fulfilled by Authority.
7 Additional Performance Security @ 10% difference between Bid Project Cost and Estimated Project Cost, if BPC < EPC by 10% or more. 9.7 New Addition: Safeguards against aggressive bids, while retaining flexibility for market price discovery by not setting a floor.
8 Deletion from scope of work on land that cannot be provided within 180 days of Appointed Date. 10.3.4 New Addition: Welcome provision as the final scope of project gets defined within reasonable time instead of getting added right till scheduled completion date and leaving ambiguity to treatment of scope on land which cannot be acquired till end.
9 80% of Site shall mean and imply land that shall enable the Concessionaire to undertake construction on at least 80% of the length of the Project. 10.3.7 New Addition: Welcome clarification removing ambiguity in interpretation of Site, working favourably in the interest of the Project and removing a major source of disputes under MCA.
10 Schedule K Annex II as per MCA. Deleted. Controversial calculation framework, especially prone to misinterpretation of Project Highway definition in case of project incomplete due to land not available has been deleted.

Table-2: THE BAD

1 Conditions Precedent - Timeline for Authority to fulfil CPs, mainly land for 80% length, environmental permits and GADs for ROBs/RUBs. 4.1.2 MCA: 90+30 (extendable to 60) i.e. 150 days (5 months). Additional time for environmental and railway approvals. HAM: 30+120+90 = 240 days (8 months): without any damages. Stretching timelines as above to 8 months negates the principle that time shall be of essence [Cl. 1.2.1 (x)].
2 Representation that: it [Authority] shall procure good and valid right to Site.... 7.2 (h) Diluted from Representation in MCA that: it [Authority] has good and valid right to Site..
3 Release of Performance Security: earlier of 1 year or expenditure of 30% of Bid Project Cost. 9.3 New condition is onerous as it blocks substantial guarantee limits. MCA: 1 year or 20% of TPC may be restored.
4 Deemed Performance Security (DPS) equal to Performance Security throughout Concession Period. 9.4 New Addition: Authority to have first charge in the amount of DPS in Escrow Account. Damages for delay in during construction (12.3.2) and O&M (17.7.3 & 17.7.4) are provided. This amounts to duplication of penalties. This is a draconian condition, especially extending throughout the Concession Period and not in the spirit of partnership. Besides, first charge to Authority is an impediment to Financial Closure.
5 Costs & expense of felling of trees to be borne by Concessionaire. 11.4 (Changed from MCA: Cost of felling of trees to be borne by Authority). It is a difficult or near impossible task for Concessionaire to ascertain the nature and extent of tree felling and therefore associated costs & expense cannot be estimated at the time of Bid and even up to Financial Close. Inadequate provision on this account would require promoters to make up the shortfall. Provision of unencumbered and obstruction free land is obligation of Authority; instead in present case the risk is unduly getting passed on to Concessionaire. MCA provision should be restored.
6 Damages for delay in COD beyond 90 days from Scheduled Completion Date 15.2 MCA: 0.1% of Performance Security per day of delay. Increased to 0.2% of Performance Security and interest thereon. MCA provision to be restored.
7 Interim arrangement in the event Independent Engineer is not appointed / has relinquished its functions. 21.7 New Addition: With watered down functionality, effectiveness of interim arrangement would be suspect. Controversies would arise whether obligations of parties can be met with this interim arrangement. If interim arrangement is not to review, comment approve or inspect, it would result in Appointed Date and force Concessionaire to commence work with no liability on Authority. Work done under such ad hoc arrangement would result in disputes. May be deleted and Authority must adhere to its obligations of timely appointment and replacement of IE.
8 Timeline for Financial Close (without incurring damages) is 150 days. 22.1.1 MCA: 180 days. Given the 240 day timeline for Authority to fulfil its Conditions Precedent without incurring penalties, this unilateral reduction is meaningless. Reasonableness of 180 day timeframe is also borne from experience on vast number of previous projects.

Table-3: & THE UGLY

1 Reduction in Scope of the Project 16.6 Changed from MCA. The new version has several conceptual flaws and there is a mathematical glitch in the formula for calculating impact of reduction in scope.Conceptual flaws:i. Reduction in scope will be onetime (or few discrete) event(s), and the impact of same must be dealt with accordingly.ii. In case of reduced change of scope, the settlement must be on one-time payment to be made by Concessionaire in lieu of its obligations, without tampering with the Annuity Payments and O&M Payments.iii. The HAM provision requires revision to Bid Project Cost and consequent adjustments to Payment Milestone instalments and also Annuity payments, thus impacting the very fundamentals of the Concession. Uncertainty is introduced in the not only in the quantum but also in timing (COS claims take long to be determined) of revenue stream adversely impacting the bankability of the Hybrid CA.iv. The formula requires double adjustment to the Bid Price Cost. The second adjustment is unnecessary, especially once the fact that BPC can be more than, equal to or less than EPC is an agreed term (Cl. 23.1).Mathematical discrepancy: The formula for double adjustment of BPC works as long as BPC is equal to EPC. In case BPC>EPC (more likely to be the case), the pay-out to the Concessionaire is actually more than the reduction in scope cost!MCA provision may be retained.
2 Effect of Change of Scope on the O&M Costs 16.7 New Addition:i. The provision assumes that all sections of the Project Highway are homogeneous and therefore linear adjustment to O&M Payments is envisaged.ii. Effects of terrain, ground conditions, major structures etc. resulting in a varying cost profile for different sections of the Project is not factored in, thus leading to erroneous result.iii. Also, COS may not necessarily result in change in executed length.iv. Again, uncertainty is introduced in the revenue stream adversely impacting the bankability of the Hybrid CA.v. Adjustment to increase or reduction in O&M expenses can be made during determination of COS cost itself.
3 Penalty in delay in re-opening of part closed for maintenance @ 0.5% of Performance Security per day. 17.7.3 Penalty amount is too high and draconian and would be many times value of maintenance work itself in most cases.
4 Payment during Construction Period 23.4 i. IE along with Authority to determine weightages during finalization of design: Discretionary power to IE and Authority.ii. Complete design process may take several months, especially if entire land is not available upfront, which is likely in most cases. This will delay determination of weightages and hold up payments to Concessionaire.iii. IE to certify Physical Progress: discretionary power to IE. Moreover, no timeline for certification by IE is specified.iv. Revenue stream considered at time of bid / financial close may not materialize bankability issue.v. Physical Progress subject to Change of Scope: Determination of cost and time impact of COS is time consuming. Holding up payment for same would disrupt cash inflow schedule. COS must be delinked from stage Payments during Construction Period would be in the nature of capital receipts and must be exempt from corporate income tax. This needs to be clearly specified. Else, this will result in hassles for the Concessionaire vis-a-vis the tax authorities. In case the exemption is not available, a chunk of receipt will simply flow back to the government, with no value added but in fact bloating the project cost.
5 Bonus on early completion 23.5 i. Bonus of 0.5% of 60% of Bid Project Cost for every month of early completion is miniscule and inadequate to cover the cost and effort to achieve early completion, which is desirable in any project. ii. Bonus must be calculated as annuity on per diem basis irrespective of number of days of early completion.
6 Annuity Payments during Operation Period 23.6.3 i. Payment schedule is back-ended impacting viability and attractiveness of the Project.ii. Virtually dictates the schedule of repayment of principal of debt.Iii. Back-ended repayment of principal would increase the interest outgo for the project.
23.6.4 i. "Completion Cost" as base for calculating interest payment may be inappropriate and a potential source of major disputes.ii. Payment of interest rate payment at Bank Rate + 3% must be made sacrosanct,Irrespective of and notwithstanding the actual rate of interest on debt raised.iii. Following are pitfalls of fixing the rate for interest payments:a. In case actual rate is higher, it does not cover the entire interest rate riskb. It is a disincentive to lenders to offer lower rates, even if the project and promoter profile make it possible, thus depriving the project of private sector efficiency.c. In case actual interest rate is lower (as disclosed in Financing Agreement submitted to Authority), in the absence of "notwithstanding" provision as suggested in (ii) above, will the Authority make payments as specified in the Agreement? Or will it cite oversight of watchdog agencies and restrict payments to actual interest rates? This is a potential source of uncertainty to revenue stream and would give rise to disputes.
8 O&M Payments 23.7 i. O&M Payments do not provide for periodic Major Maintenance and replacement cycles.ii. Smoothening of O&M Payments, as presently required to cover for major maintenance & replacement expenses, is incorrect.iii. In case such smoothening is envisaged, definition of O&M Expense must explicitly permit and include provision for creation of Major Maintenance and replacement reserves.iv. Otherwise, such smoothening will reflect a wide gap between the O&M Payments and O&M Expenses in regular O&M years (as seen in Audited Financial Report), and would be a potential point of conflict and dispute between the Authority and Concessionaire.
9 Treatment of incomplete works 23.9.2 i. In case incomplete works are considered as reduced change of scope, the settlement must be on one-time payment to be made by Concessionaire in lieu of its obligations, without tampering with the Annuity Payments and O&M Payments.
10 Termination Payments Article 28 (Force Majeure) and Article 31 Termination i. Termination Payments calculations assume Physical Milestone payments have been made (this may not be the case in events of Disputes), and thus only consider 60% of Bid Project Cost as a basis of computation.ii. In case of termination happening between two milestones, for the purpose of calculation of Debt Due, the milestone achieved would only be considered. This is draconian.,a. The 1st milestone is upon 20% Physical Progress; subsequent 2nd & 3rd are upon further 20% and 4th & 5th upon further 15% progress respectively.,b. In case physical progress is made close to the next milestone (especially in case of 1st, 2nd and 3rd, close to 20%) but is not certified, such expenditure is not covered by Termination Payment at all. In real life situations, in case of an imminent Termination event, irrespective of status of completion of work, chances of certification of next milestone become extremely bleak.,c. In such a scenario, Concessionaire would be required by Lenders to provide Termination shortfall support, which is customary, to the tune of 20% of project cost. By way of illustration, for a Rs. 2000 crore project, this amounts to a Rs. 300 crore requirement (assuming 75:25 D:E ratio; equity being entirely at risk being the double whammy)!!,d. If at all there is a case to employ the services of the Independent Engineer during the concession, it would be in this instance to determine the value of progress beyond last achieved milestone, in order to arrive at a correct basis for calculation of Termination Payment. It is unfathomable why this has been ignored.Iii. With such large liability looming, Concessionaire would practically NEVER call an Authority Default, thus letting the Authority to default on its obligations with impunity. In effect, the HAM Agreement causes the Concessionaire to bear all project risks, including those related to Authority obligations. This seriously mars the risk sharing mechanism envisaged in a public-private partnership.
11 Change In Law 35.1 Increase in cost: The increased costs arising from Change in Law have real impact on financials of the Concessionaire. In absolute terms, threshold of Rs. 1 crore per annum itself is high enough. Linking it further to 2% of Annuity Payments in a year would raise it further in many cases, causing undue burden on the Concessionaire.
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