“The court recognizes the difficulties presented by § 1129(b)(2)(A) for real estate developers trying to reorganize, but Congress has decided that debtors must bear the risk of reorganization by contributing additional capital and/or pledging additional collateral to their undersecured creditors before debtors may enjoy the benefits of a confirmed plan.”
Single asset real estate (“SARE”) Chapter 11 cases have been recognized by the United States bankruptcy laws in one way or another since 1938, when Congress, in enacting the Chandler Act, included a separate chapter for real estate reorganizations by non-corporate debtors – old Chapter XII of the Bankruptcy Act of 1898. The Bankruptcy Reform Act of 1978 combined old Chapters X, XI and XII into new Chapter 11 of the Federal Bankruptcy Code providing for business reorganizations. SARE Chapter 11 cases came to the fore during the 1989-1992 recession, which severely impacted commercial real estate. During this recessionary period and for several years thereafter, many SARE debtors filed Chapter 11 petitions seeking to reorganize their businesses over the objections of their primary secured creditors. In 1994, Congress amended the Bankruptcy Code by adopting a new definition, “single asset real estate,” in section 101(51B) and added section 362(d)(3) to the Code, which was specifically designed to enable secured creditors to seek relief from the automatic stay in SARE cases on an expedited basis. Although SARE cases diminished in number and importance from 1995 through 2008, the world financial crisis beginning in September 2008 resulted in their resurgence. In recent years, there have been a relatively small number of reported court decisions confirming SARE Chapter 11 plans over the objections of secured creditors. As the commercial real estate market continues to experience slow and incremental growth, we should expect to see more reported decisions on the topics of dismissal or conversion of SARE cases, relief from the automatic stay in these cases and objections to confirmation of SARE plans.
A. Statutory Definition of “Single Asset Real Estate”
As noted above, Congress enacted many changes and additions to the Federal Bankruptcy code in 1994. One significant addition made was the definition of “single asset real estate” contained in 11 U.S.C. § 101(51B). This provision defines SARE as:
“real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property or activities incidental.”
Since this statutory addition, a number of courts have strictly construed the element of this definition requiring that “no substantial business” may be operated on the real estate by the debtor “other than the business of operating the real property or activities incidental.” Thus, courts have held that, because of various ancillary business activities conducted by hotels and golf clubs, these entities do not qualify as SARE debtors. See, e.g., In re JJMM International Corp., Case No. 11-76540-ast (Bankr. E.D. N.Y. Feb. 15, 2012); In re Whispering Pines Estates, 341 B.R. 47 (Bankr. E.D. Pa. 1995); In re Spencer Creek Properties, 2010 Bankr. LEXIS 3799 (Bankr. M.D. Tenn. 2010); In re Prairie Hills Golf & Ski Club, 255 B.R. 228 (Bankr. D. Neb. 2000); In re Scotia Pacific Co., LLC, 508 F.3d 214 (5th Cir. 2007). See generally Kenneth N. Klee, One Size Fits Some: Single Asset Real Estate Cases, 87 Cornell L. Rev. 1285 (2002).
Recently, one SARE debtor that was a member of an integrated corporate group attempted to avoid classification as an SARE debtor by arguing that there is a “whole enterprise” exception to the SARE definition that would insulate it from being classified as an SARE debtor. This argument was rejected by the Ninth Circuit Court of Appeals in In re Meruelo Maddox Properties, Inc., 2012 WL 248167 (9th Cir. Jan. 27, 2012). See also In re Kara Homes, 363 B.R. 399 (Bankr. N.J. 2007).
B. Section 362(d)(3) of the Bankruptcy Code
Congress also added new section 362(d)(3) to the Bankruptcy Code via the 1994 Amendments. This provision specifies new grounds for granting relief from the automatic stay in SARE cases. Thus, in order to avoid the entry of an order granting relief from the automatic stay on the motion of a mortgagee or the holder of a deed of trust in the debtor’s real estate, the debtor must either: (i) file within 90 days after the date on which the debtor filed its Chapter 11 petition (or within such later date as determined by the bankruptcy court “for cause”) or within 30 days after the bankruptcy court determines that the debtor is a SARE debtor, a plan of reorganization having “a reasonable possibility of being confirmed within a reasonable time,” 11 U.S.C. § 362(d)(3)(A), or (ii) commence making monthly payments to the secured creditor from rents or other revenues generated by the project “in an amount equal to interest at the then applicable nondefault rate of interest on the value of the creditor’s interest in the real estate” within the same time periods. 11 U.S.C. § 362(d)(3)(B). For representative court decisions construing this provision, see In re National/Northway Ltd. Partnership, 279 B.R. 17 (Bankr. D. Mass. 2002); In re Planet 10, L.C., 213 B.R. 478 (Bankr. E.D. Va. 1997).
II. Commencement of a SARE Chapter 11 Case and the Automatic Stay
A. Setting the Stage
The commencement of a SARE case is normally not a surprise to anyone. The filing of petitions by SARE debtors are often preceded by attempts by the secured creditor post-default to collect rents generated by the mortgaged realty and to foreclose on its lien in that realty. As will be discussed below, rents are sometimes not available to a debtor for use in a SARE Chapter 11 case depending upon whether (i) a particular rent assignment is structured as an absolute assignment and not as one for security; and (ii) whether the secured creditor holding the rent assignment has taken action in accordance with the assignment contract and applicable state law to terminate the debtor’s interest in rents prior to the case’s commencement.
B. Imposition and Impact of Automatic Stay
Upon the commencement of a SARE Chapter 11 case, the automatic stay provisions will be immediately imposed to protect the debtor from the initiation and continuation of creditor actions to collect indebtedness and to foreclose upon liens in property of the estate that secure repayment of the secured debt. 11 U.S.C. § 362(a). The automatic stay’s function is to provide a “breathing spell” during which a Chapter 11 debtor can attempt to reorganize its business pursuant to a confirmed plan. H.R. Rep. No. 595, 95th Cong., 1st Sess. 340 (1977). Thus, creditor actions to exercise rights under rent assignments where the debtor still holds an interest in the rents will normally be prohibited by the automatic stay. Most actions to foreclose real estate mortgages and deeds of trust are also enjoined by the automatic stay and, to the extent that they take place after imposition of the stay, the foreclosure sale will be deemed void or voidable. See, e.g., ACands, Inc. v. Travelers Cas. & Sur. Co., 435 F.3d 252 (3d Cir. 2006).
C. Seeking Relief from the Automatic Stay
Creditors may also file motions for relief from the automatic stay on the grounds described in 11 U.S.C. §§ 362(d)(1) and 362(d)(2). These two sections provide the more “orthodox” grounds that permit a secured creditor of a SARE debtor to obtain relief from the automatic stay. The first such ground is “for cause, including lack of adequate protection” of the secured creditor’s lien or security interest in the project and/or the rents generated therefrom. 11 U.S.C. § 362(d)(1). A relatively recent decision of the Bankruptcy Appellate Panel of the Sixth Circuit Court of Appeals held that the offer by a SARE debtor to grant a replacement lien in after-acquired, post-petition rents to permit the debtor to use those rents to pay postpetition operating expenses and other debts did not constitute adequate protection where there was no equity cushion in the debtor’s property. In re Buttermilk Towne Center, LLC, 442 B.R. 558 (6th Cir. BAP 2011). The failure to provide adequate protection to a secured creditor with an interest in rents will normally prohibit the debtor from using this cash collateral during the SARE case and should result in granting relief from the automatic stay to permit the secured creditor to collect the rents. See also In re Smithville Crossing, LLC, 2011 WL 5909527 (Bankr. E.D.N.C. Sept. 28, 2011); In re Murray, 2011 WL 5902623 (Bankr. E.D.N.C. May 24, 2011); In re Union-Go Dairy Leasing, LLC, 2010 WL 1848485 (Bankr. S.D. Ind. Mar. 6, 2010). In addition, the commencement of an SARE Chapter 11 case by a debtor with few assets and little or no business may constitute a lack of good faith that could result in granting relief from the automatic stay upon the motion of a secured creditor for “cause” under 11 U.S.C. § 362(d)(1). See, e.g., In re Laguna Associates Ltd Partnership, 30 F.3d 734 (6th Cir. 1994); In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293 (Bankr. D. Del. 2011).
The other orthodox basis for a secured creditor seeking relief from the automatic stay is where (i) the debtor lacks equity in the collateral; and (ii) where the collateral is not necessary for the debtor’s “effective reorganization.” 11 U.S.C. § 362(d)(2). In determining whether the debtor lacks equity in the collateral, all encumbrances on the property are considered. In determining whether the property is necessary for the debtor’s effective reorganization, the ability of the debtor to reorganize must be more than “fanciful” and be based on verifiable research and financial analysis. In re Pegasus Agency, Inc., 101 F.3d 882 (2d Cir. 1996). See also In re Grand Traverse Development Co. Ltd. Partnership, 150 B.R. 176 (Bankr. W.D. Mich. 1993).
D. Seeking Dismissal or Conversion of SARE Chapter 11 Cases
Section 1112(b)(1) of the Bankruptcy Code, which was last amended in 2005, provides that a bankruptcy court may dismiss or convert a Chapter 11 case to Chapter 7 upon the filing of a motion when (i) the moving party establishes “cause” for such dismissal or conversion and (ii) when the court does not find that “unusual circumstances” render dismissal or conversion not to be in the best interests of creditors and the estate. Section 1112(b)(4) states that the term, “cause,” includes (but is not limited to) a list of 16 separate factors but does not include among them the filing of a Chapter 11 petition in “bad faith.” Nevertheless, bankruptcy courts have consistently included bad faith Chapter 11 filings as instances of “cause” justifying dismissal or conversion of the case. See, e.g., In re Victory Construction Co., 9 B.R. 549 (Bankr. C.D. Cal. 1981); In re Philadelphia Rittenhouse Developer LLP, 2011 Bankr. LEXIS 1930 (Bankr. E.D. Pa. 2011).
Some early court decisions required only a showing of “subjective” bad faith to justify dismissal or conversion of a Chapter 11 case for cause. For example, the Eleventh Circuit Court of Appeals in the 1980s adopted this approach, listing the following six factors that, if present, would support a finding of bad faith:
(a) the debtor has only one asset;
(b) the debtor has few unsecured creditors whose claims are small in relation to the claims of secured creditors;
(c) the debtor has few employees;
(d) the property is subject to a foreclosure action due to arrearages on the secured debt;
(e) the debtor’s financial problems are a dispute between the debtor and secured creditors that could be resolved in a pending state court action; and
(f) the timing of the debtor’s Chapter 11 filing evidences an intent to delay or frustrate the legitimate efforts of the secured creditors to enforce their rights.
In re Phoenix Piccadilly Ltd., 849 F.2d 1393, 1394-95 (11th Cir. 1988). See also In re Little Creek Development Co., 779 F.2d 1068 (5th Cir. 1986); In re State Street Houses, Inc., 356 F.3d 1345 (11th Cir. 2004) (per curium). Cf., In re Harco Co. of Jacksonville, LLC, 331 B.R. 453 (Bankr. M.D. Fla. 2005).
Other courts have required a showing of subjective and objective bad faith as a necessary prerequisite for dismissal or conversion of a SARE Chapter 11 case for “cause.” Objective bad faith requires a showing that, given the debtor’s economic circumstances and the status of the Chapter 11 case, the debtor’s efforts to reorganize in Chapter 11 are objectively futile. See, e.g., Carolin Corp. v. Miller, 886 F.2d 693 (4th Cir. 1989); In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009); In re Philadelphia Rittenhouse Developer, LLC, 2011 Bankr. LEXIS 1930 (Bankr. E.D. Pa. May 25, 2011) for courts adopting the dual standard for a finding of a bad faith Chapter 11 filing. Examples of facts that, if established at a hearing on a motion to dismiss or convert a SARE Chapter 11 case, will satisfy the objective standard for a bad faith filing are (i) the debtor’s proposed plan violates the absolute priority rule; and (ii) the debtor will be unable to obtain one impaired class accepting the plan as required by 11 U.S.C. § 1129(a)(10). See, e.g., In re Woodbrook Associates, 19F.3d 312, 316 (7th Cir. 1994); In re DCNC North Carolina I LLC, 407 B.R. 651 (Bankr. E.D. Pa. 2009).
III. Use of Property of the Estate and Granting Adequate Protection
A. Property of the Estate in SARE Cases
Upon the commencement of a SARE Chapter 11 case, an “estate” is created that will consist of “property of the estate” within the meaning of 11 U.S.C. 541(a). Property of the estate will consist of tangible and intangible real and personal property in which the debtor has an interest that is substantial. See, e.g., United States v. Whiting Pools, Inc., 462 U.S. 198, 103 S.Ct. 2309 (1983). In the event that the debtor suffers the loss of its interest in the property prior to the commencement of the bankruptcy case, then that property does not constitute “property of the estate” and, thus, cannot be used by the debtor during the course of its Chapter 11 case. See generally In re Rodgers, 333 F.3d 64 (2d Cir. 2003).
An example of the foregoing involves rents that are the subject of a prepetition assignment for the benefit of a creditor that is either (i) an absolute assignment of rents and enforced as such under applicable state law; or (ii) an assignment of rents as security where the creditor has taken all necessary steps under applicable state law to terminate the debtor’s interests in those rents prior to the petition date. Bankruptcy decisions that enforce absolute assignments and prohibit the debtor’s use of rents include In re Jason Realty, L.P., 59 F.3d 423 (3d Cir. 1995). Contra, LT Propco, LLC v. Carousel Ctr. Co., L.P., 68 A.D.3d 1695 (N.Y. App. Div. 4th Dep’t 2009); In re Senior Housing Alternatives, Inc., 444 B.R. 386 (Bankr. E.D. Tenn. 2011) and the cases and commentary cited therein. There are a number of reported decisions holding that the exercise of rights under an assignment of rents prior to the commencement of a bankruptcy case by the assignor results in the prepetition termination of the assignee’s interest in those rents. Consequently, the rents will not be treated as “property of the estate” and “cash collateral” available for use by the debtor. See, e.g., In re Mount Pleasant Ltd. Partnership, 144 B.R. 727 (Bankr. W.D. Mich. 1992); In re Woodmere Investors Ltd. Partnership, 178 B.R. 346 (Bankr. S.D.N.Y. 1995) (applying Michigan law). Contra, In re Newberry Square, Inc., 175 B.R. 910 (Bankr. E.D. Mich. 1994).
B. Adequate Protection Requirements
Section 363(e) of the Bankruptcy Code prohibits a debtor from using, selling or leasing property of the estate subject to a lien unless the lienor consents to such use, sale or lease or the bankruptcy court permits such action after notice and a hearing and after granting adequate protection to the secured creditor. As noted above, the recent decision of In re Buttermilk Towne Centre, LLC, supra, held that the grant of replacement liens in postpetition rents subject to a valid, prepetition rent assignment does not constitute adequate protection where the debtor lacks equity in its property. Contra, In re Addison Properties Limited Partnership, 185 B.R. 766 (Bankr. N.D. Ill. 1995). For an excellent discussion of adequate protection issues arising in SARE Chapter 11 cases, see David R. Kuney and Alex R. Rovira, The Single Asset Real Estate Cases, pp. 69-84 (ABI 2012).
IV. Plan Confirmation Issues in SARE Chapter 11 Cases
A. Plans in General
The SARE debtor, if it is able to do so, will likely propose a Chapter 11 plan for the reorganization of its business and the retention of the secured creditor’s collateral. The common object of SARE plans is to restructure the secured indebtedness so that it is paid over a period of time longer than the loan term at an interest rate lower than the contract interest rate. In proposing such a plan, the debtor will normally address and resolve issues relating to (i) classification and treatment of claims for purposes of the plan; (ii) creation of an impaired, non-insider class of claims that is expected to accept the plan; (iii) the cramdown of the class of secured creditors that are expected to reject the plan and object to confirmation; (iv) the invocation of the “new value exception” to the absolute priority rule to permit equity holders to retain their interests in the debtor while not paying a dissenting senior class in full; and (v) the plan’s feasibility.
B. Classification of Claims
In classifying claims for purposes of the plan, the debtor will likely be confronted with an undersecured creditor with first priority liens in the project, rents and other assets. If the lender is hostile to the debtor and the debtor is unable to resolve economic and other issues with this creditor outside of a Chapter 11 plan or in a consensual plan, then the debtor is likely to propose a plan to cram down the secured creditor’s claim and liens. In such a plan, the debtor may create one class for the lender’s secured claim and another, separate class in which the lender’s unsecured, deficiency claim will be placed. The debtor may also create a separate class of unsecured, “friendly” claims that the debtor anticipates will accept the plan. Whether or not the lender’s deficiency claim may be classified separately from the claims of other, unsecured creditors differs among the Circuit Courts of Appeal. See, e.g., In re Boston Post Road Ltd. Partnership, 21 F.3d 477 (2d Cir. 1994); In re Bryson Properties, XVIII, 961 F.2d 496 (4th Cir. 1992); John Hancock Mut. Life Ins. Co. v. Route 37 Business Park Associates, 987 F.2d 154 (3d Cir. 1993); In re Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991); In re U.S. Truck Co., 800 F.2d 581 (6th Cir. 1986); In re Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994); In re Lumber Exchange Bldg. Ltd. Partnership, 968 F.2d 647 (8th Cir. 1992); In re Johnston, 21 F.3d 323 (9th Cir. 1994); In re Loop 76 LLC, 465 B.R. 525 (9th Cir. B.A.P. 2012). Undersecured creditors whose claim is non-recourse may attempt to block confirmation of a Chapter 11 plan by making an election under 11 U.S.C. 1111(b)(2) to have their claims treated as fully secured. In making this election, these claims will be allowed in their full amount but will be paid under the plan an amount equal to the face amount of their claims over time, the present value of which payments must equal the amount of their secured claims only. See, e.g., In re Brice Road Developments, L.L.C., 392 B.R. 274 (BAP 6th Cir. 2008); In re Saguaro Ranch Development Corp., 2011 WL 2182416 (Bankr. D. Ariz. June 1, 2011) for representative decisions.
C. Acceptance by Impaired Class of Claims
In order to obtain confirmation of a plan that impairs at least one class of claims, the debtor must obtain acceptance of at least one accepting, non-insider class. 11 U.S.C. § 1129(a)(10). Some courts hold that an accepting, impaired class of claims that is “manufactured . . . doesn’t count even though there may be literal compliance with Code 1129(a)(10).” In re Windsor on the River Associates, Ltd., 7 F.3d 127 (8th Cir. 1993). Other courts reject this judicial gloss on the statutory confirmation standards. See, e.g., In re L&J Anaheim Associates, 995 F.2d 940 (9th Cir. 1993).
D. Cramdown of Dissenting Classes of Secured Creditors
Assuming that the secured creditor holding a non-recourse claim in a SARE Chapter 11 case does not make the election under 11 U.S.C. 1111(b)(2) to have its claim treated as fully secured, and if the class containing its secured claim votes to reject the plan, then in order to confirm the plan, the debtor must “cram down” that class in its plan. 11 U.S.C. § 1129(b)(2)(A). If the debtor seeks to retain the secured creditor’s collateral, then the debtor must pay the value of that collateral to the creditor at once or over time at an interest or discount rate, which is used to compensate the creditor for (i) the time value of money; (ii) inflation risk; and (iii) default risk. The interest or discount rate applicable in SARE Chapter 11 cases is likely to be determined according to the standards set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004), as interpreted in the Chapter 11 context by other courts, notably the Sixth Circuit Court of Appeals in In re American HomePatient, Inc., 420 F.3d 359 (6th Cir. 2005). In this decision, the Sixth Circuit held that a secured claim being crammed down in a Chapter 11 plan will be paid at an interest rate determined according to the prevailing market rate, assuming that there is an efficient market to set that rate. Where no such market exists, then the bankruptcy court should use the formula approach described in Till, which requires the use of some current baseline index (normally the current prime rate of interest) as establishing the time value of money, adjusted upward for default risk. See In re Griswold Building, LLC, 420 B.R. 666 (Bankr. E.D. Mich. 2009) for an example of a contested Chapter 11 confirmation hearing that utilized the Till formula. See also In re American Trailer & Storage, Inc., 419 B.R. 412, 434 (Bankr. W.D. Mo. 2009).
A Chapter 11 plan may be confirmed over a secured class’ dissenting vote if the plan provides that the class members receive the “indubitable equivalent” of its claim. 11 U.S.C. § 1129(b)(2)(A)(iii). There are several methods available to provide the indubitable equivalent to a secured creditor including cash payments, abandonment of collateral and substitution of collateral. See, e.g., In re SUD Properties, Inc., Case No. 11-03833-8-RDD (E.D.N.C. August 23, 2011); In re Saguaro Ranch Development Corp., 2011 WL 2182416 (Bankr. D. Ariz. June 1, 2011); In re Bryant, 439 B.R. 724 (E.D. Ark. 2010). See also In re Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989); In re Philadelphia Newspapers, 599 F.3d 298 (3d Cir. 2010); In re Briscoe Enterprises, Ltd., II, 994 F.2d 1160 (5th Cir. 1993); In re Monnier Bros., 755 F.2d 1336 (8th Cir. 1985).
E. New Value Exception to Absolute Priority Rule
If an undersecured non-recourse creditor of an SARE debtor does not make the section 1111(b)(2) election, that creditor’s unsecured claim determined under section 506(a) of the Bankruptcy Code may be sizeable enough to control the voting of the unsecured creditor class that this claim has been placed in pursuant to the debtor’s plan. If that class will not receive payment in full of its claims under the plan and votes to reject the plan, the debtor’s may secure confirmation only by invoking the “new value contribution” exception to the absolute priority rule. See, e.g., Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988); Bank of America Nat. Trust and Sav. Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999). The contribution must be substantial and made in money or money’s worth; sweat equity does not qualify. Ahlers, supra.
There is an interesting line of cases in which SARE Chapter 11 debtors have sought to avoid the application of the absolute priority rule when a senior dissenting class will not be paid in full under the plan by effectively transferring the equity interests in the debtor to a relative of the holder or holders of “old equity” pursuant to the plan. One such decision is In re Greenwood Point L.P., 445 B.R. 885 (Bankr. S.D. Ind. 2011), where the plan provided that a 99% equity interest in the limited partnership debtor would be extinguished and new equity interests would be issued to the wife of the former controlling partner. In confining the plan, the bankruptcy court held that section 1129(b)(2)(B)(ii) of the Code prohibited only current holders from retaining their equity interests or obtaining issuance of new equity under the plan in the absence of a new value contribution. In In re Global Ocean Carriers Limited, 251 B.R. 31 (Bankr. D. Del. 2000), however, the bankruptcy court refused to confirm a plan that provided for the transfer of the major shareholder’s equity interest to his daughter who lacked any preexisting equity interest in the debtor. The bankruptcy court found that this plan ran afoul of the absolute priority rule when a senior dissenting class would not be paid in full and where no public auction of the equity would be held. See also In re Beal Bank SSB v. Waters Edge Ltd. P’ship, 248 B.R. 668 (D. Mass. 2000); Troy Savings Bank v. Travelers Motor Inn, Inc., 265 B.R. 485 (N.D.N.Y. 1997); In re Woodscape Ltd. Partnership, 134 B.R. 165 (Bankr. D. Md. 1991).
In order to be confirmed, a reorganization plan must be feasible, viz., confirmation of the plan will not likely be followed by the liquidation or the further financial reorganization of the debtor or any successor to the debtor unless that liquidation is contemplated by the plan. 11 U.S.C. § 1129(a)(11). In order to satisfy this test, the debtor must establish through reliable financial projections that it will be able to make payments under the confirmed plan. See, e.g., In re Made in Detroit, Inc., 299 B.R. 170 (Bankr. E.D. Mich. 2003). Generally speaking, the longer the period of time that payments are to be made under a proposed plan, the more difficult it will be for a debtor to satisfy through financial projections the feasibility requirement for confirmation. See, e.g., In re Griswold Building, LLC, 420 B.R. 666 (Bankr. E.D. Mich. 2009); Cf., In re Bryant, 439 B.R. 724 (Bankr. E.D. Ark. 2010) (12-year term of plan deemed feasible).
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