PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 14

 - The Political and Judicial Elements of American Capitalism


Professor Rae uses the Merck-Vioxx business case to highlight political elements of U.S. capitalism, including government regulatory agencies, federalism, lobbying, regulatory capture, tort law and liability, and patent law. Professor Rae discusses the importance and influence of concentrated business interests in Washington DC. The Merck legal battles underline how important political and judicial details are in the operation of capitalism. The case also shows the constraints that reform-minded politicians face in attempting to change the status quo.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 14 - The Political and Judicial Elements of American Capitalism

Chapter 1. Introduction: Using Merck-Vioxx as a Main Case [00:00:00]

Professor Douglas W. Rae: Okay, so heretofore in this course we have treated government as one of two things: either, as in de Soto’s frame of reference, a guarantor of property rights; or as just background material, as with Smith, where the gravamen of Wealth of Nations and the invisible hand story is to encourage governments to allow free markets and free trade. There’s not much talk about governments and how they behave. And today I wanted to correct that deficiency a little by talking about government, and in particular, about the government of the United States. Then turning to the Vioxx, the Merck-Vioxx case, and looking at a little bit of video of Mark Lanier who is the main trial lawyer litigant nationally in the Merck matter.

Now the United States is a very unusual political system. It is a so-called presidential system often copied. There are probably — I haven’t counted them, there are probably twenty, perhaps twenty-five countries with regimes that look on the surface like the American one, and they have in common that almost every one of them has failed. Almost every one of them is wildly unstable. The organic growth of the very complex American Constitutional order is essentially unique, and it begins with what I think of as the genius of the founding fathers expressed particularly in Federalist 10 and Federalist 51, where the object is to create a complex system; system which makes it hard for people to put together winning coalitions in favor of new policies; which gives enormous advantage to those defending existing policies; which, by the scale and complexity of so large a system, and they thought, when they began, of the thirteen colonies as a huge republic, and it was a huge republic. What came after is the largest complex republic the world has known, and probably it is as large as is feasible with a republican form of government.

The combination of federalism — so there are two major layers of government, and the expected diversity of so large a country make it hard to form majority coalitions. Even when you form majority coalitions, the system of checks and balances in the Constitution, augmented by the later emergence of the committee system in the House and Senate at the federal level, make putting together a winning majority very difficult. Arguably the last presidential and congressional elections created a winning coalition for some form of healthcare reform. Though one would have to admit that listening to the election wasn’t much specificity about what that might be. If you watch what’s happened since, the powerful resistance to change which is built into the system has manifested itself.

Now from the point of view of capitalism, it is generally supposed that this is a plus. That the stability of economic policy and the endurance of laws relating to property patents, commerce, that the relative stability of all that owes something to the fact that no mere short-lived majority can transform the American political system and its policies. I think that’s broadly true. The only contingency in which one would fear for the American republic, and there are people — New York Times columnist Frank Rich, for example, New York Times columnist David Brooks for another example, who fear that we’ve come to that difficult position, and that position is this: if the existing status quo is unsustainable, as one might have thought the status quo on the regulation of banking and mortgages was six months or a year ago, and as some argue the healthcare system is now, then all the checks and balances which make change difficult may make it impossible to escape from that very difficult status quo.

Now I am personally an optimist about the ingenuity and resilience of the American and political and economic order, but it’s important right now to begin what we’re doing today, understanding that changing public policy is a heroic undertaking. The change of public policy, which will be in the background in the Vioxx case, is tort reform. Part — which plays a huge role in the Vioxx case, tort law does, and is in the background as a major factor in the healthcare reform story because the risk to medical practitioners from surgeons to nurses that is presented by tort law is very great and we’ll try to cover some of that using Vioxx as our case. When Vioxx was in the testing stage I went to my internist and tried to talk him into getting me into the trial because I was still playing tennis then, and Vioxx allowed me to — Vioxx seemed like a miracle drug. The merit of it, a Cox-2 inhibitor, was that it seemed to reduce inflammation in your joints and therefore reduced pain without creating inflammation and erosion in the intestine. Aspirin and other similar drugs reduce inflammation in the joints, but, as a byproduct, tear at the intestine. He was wise enough to say, “You know, not every innovation is what it appears to be, and I would urge you not to be in the trials.” Being a compliant fellow I took his advice, and in retrospect, I guess I’m glad.

Chapter 2. Patterned Advantage [00:08:07]

The American system, and this is not part of the original design, has built up an enormous practice in lobbying and high powered lawyering at the federal level, and K Street is to lobbying what Wall Street is to finance. The existence of trade associations for every imaginable thing is a leading factor in American politics, and whomsoever would seek to control or create some new efficiency or new form of justice in public policy has to fight her or his way through K Street. The — I’m about to give you a series of generalizations which are broadly true, each admits of exceptions, but they are about what are the advantages if we want to play the K Street game? One is concentrated interests, where a particular class of individuals or companies have a lot at stake, is a huge advantage. Why is it a huge advantage? Because it will provoke them to spend money on lobbying and influence, and they will have the money. Whereas, as disbursed interests, where there are perhaps tens of thousands or even millions of people who have small stake in an outcome will not readily form a well financed interest association, and will therefore be less strong than a concentrated set of interests which form a well financed coalition.

It goes with the second point as a truism. Well-financed causes trump poorly financed ones. There are exceptions to that but not a lot. Remember that it is a market society, and money talks. It is a market society in which the first amendment gives money rights; that is, if I want to spend money putting forth a point of view and you want to regulate my right to do that, my first recourse of defense for the right will be to go to the courts and say that you’re infringing my right of self expression. And the courts have often, not unambiguously, but often, ruled in favor of that view. Defending the status quo is a hell of lot easier then changing it. The legislative process is full of veto points. The commonest result for legislation introduced in the House of Representatives is that it is assigned to a committee and nothing else happens. It’s assigned to a committee and nobody brings it to the floor for a vote. The committee may not even hold hearings. If the chair of the committee is hostile to it, he probably — hostile to it and he thinks it might have support, he will refuse to hold hearings in a way that’s not really the subject of this course, the succession of ways in which you can kill new legislation is spectacular.

Another issue, the one about agency — agency capture is a big advantage. By this we mean that if you are in the airline business, let us say, and there is a Civil Aeronautics Bureau, which is assigned the task of regulating your industry, if your industry can make an alliance with that agency itself, can capture the agency, that can be worth an enormous economic sum because it will allow you to structure public policy in a way which suits the combined interests of your industry. Something of the same is said to be at play, and almost certainly is at play, in the relationship between the pharmaceutical interest and the FDA. I’ve just said that and that at the same time.

The CAB, Civil Aeronautics Bureau, ruled the airline industry from its inception until the late 1970s. In the late 1970s it was repealed. The regime it created assigned routes to particular companies, so you would apply to the government for the right to fly from LaGuardia in Chicago to — LaGuardia, New York to Midway in Chicago, or from Midway in Chicago to LAX. The agency would assign routes to make sure that there was not undue price competition. It would protect oligarchical pricing, and that is to say highly profitable pricing. It would work the Porter Forces, if you will, to the advantage of the incumbent airlines. New entrants could be frozen out, price competition was minimal, most of the competition had to do with amenities, most famously with airline attendants averaging twenty-five years of age, and all women and none married. The air travel business was restricted and wildly inefficient. What killed this arrangement was the observation made by some law and economics people that the airlines which were not subject to it, and the only airlines that weren’t subject to this regulation were ones which flew entirely in one state, and the most famous case was the flight between the San Francisco/Oakland area and the LA/San Diego area, where fares were low, they were less than half comparable fares on interstate flights. A similar story in Texas from Love Field, Dallas in a hub pattern around the state of Texas, fares were lower, safety was just as good, service wasn’t quite as good, but there was genuine price competition. This group came to the fore and created a national coalition to deregulate the airlines.

The effect was well let’s take somebody at random. Who’s had — how many of you look forward to air travel? Somebody want to give us a thirty second essay on why it’s hard to — why it’s not a lot of fun to travel by air? I’ll save us time. It’s because flights are by and large full and the Transportation Safety Administration provides an initial indignity on each trip, and because service is totally minimal. You have to buy your own graham crackers for lunch. It’s not — unless you fly first class or business class, which Yale does not allow except for the very highest ranking officers at the university right now, and then only on very long flights. Air travel isn’t fun at all, but what it is is efficient and it is in real terms vastly cheaper than it was under the regulatory regime. And I bring it up just to point out the advantage of regulation under the old CAB regime from the point of view of the airlines and not from the point of view of the passengers.

The effect of deregulation was a long series of bankruptcies in which the legacy carriers went broke. Those which have survived, they had gotten so fat under the old regime, that they were wildly inefficient. And most of them died off and those which survived had to go through convulsive change to get their operating costs low enough to compete with the new wave carriers such as Southwest or JetBlue. Well the FDA is, from a strategic point of view, broadly analogous to the CAB. The FDA is a huge regulatory jungle which creates powerful obstacles to new entrants, and which requires drug companies to be extremely well financed in order to get new products through the mill. The impact of that has been to create a relatively small number of gigantic pharmaceutical companies, many of them very well run, and to induce those pharmaceutical companies to aim at blockbuster drugs.

Chapter 3. Merck Background [00:18:41]

Merck is one of those companies. It’s — I’ve shown you this diagram about combining know-how with capital and motivation to get something done. In a highly regulated environment you’ve also got to worry about the regulatory and legal apparatus in a big way, and these companies are really good at that. They have adapted to the regime of the Food and Drug Administration, and are terrifically good at that, and they are able to put up pretty high barriers to competition from new entrants. The typical outcome for somebody — for a small firm which has a drug candidate, is that they get to a certain stage in the preliminary phases of testing and then sell or license the drug to one of the major pharmaceuticals. I’ll post this slide. It’s the history of Merck’s interaction with government and government’s road toward the FDA. The interesting thing, it’s in the case about Merck, is that it’s property was seized during World War I, and for the American government to seize the property of a corporation is a very rare event, but the problem was of course World War I, the Germans were the bad guys. They ended up having to buy their property back on loans from Wall Street. The reason they got the loans is that Merck was a great company, a great company with centuries of history.

The two legislative acts which are perhaps important to the background of this case are the Prescription Drug User Fee Act of 1992 and the FDA Modernization Act of 1997, both of which gave — put the drug companies in the position of funding the FDA’s investigation of their proposals. Now in looking for a blockbuster drug, think of the green square as a space representing all the possible diseases that drugs could fix. They range on the vertical scale from acute at the bottom to chronic on the top, from rare on the bottom to common on the right. I said chronic up here, or I meant chronic up here. It is obvious to you where the money is to be made in the pharmaceuticals business? Yes back left.

Student: Common and chronic.

Professor Douglas W. Rae: Pardon.

Student: Common and chronic.

Professor Douglas W. Rae: Common and chronic, because if acute, the customer may not stay alive long enough to be truly profitable, and common is — has its obvious benefit. The idea of a Cox-2 inhibitor, the business plan behind the Cox-2 inhibitor was to advertise the hell out of it and to capture a huge generation of people forty and older with bad knees, tennis elbow, all those stiff necks, all those things which go on for decades, during the seventeen year patent to make billions upon billions of dollars. Blockbuster drugs, in fact, do make billions upon billions of dollars, and there is a market failure problem with this model, which has to do with less common and more acute diseases. Many, many small disease populations get disproportionately small investment in drug research because of the logic of blockbuster drugs.

Merck has had two really famous CEOs in recent time. This is Roy — I’ve had both these guys in my classroom to teach this case at one time or another, Roy Vagelos was a — is an M.D., and a brilliant M.D. and an idealist. He at one point — I don’t know if this — is river blindness drug in this case? Yeah, the river blindness drug is one where he — the government wouldn’t pay to distribute the drug in Africa, but he just had Merck pay, and thinks he got his money back in the motivation of his research staff. Ray Gilmartin, who succeeded him, and comes in for great abuse in the Mark Lanier video we’ll look at, Ray Gilmartin is an MBA, worse yet a Harvard MBA, and was hell for leather marketer. He looked at the Cox-2 inhibitor market as the best single market available in the generation to Merck and put a huge sales force out there, and went full stop, and sometimes a little over the line, with the ethics of inducing doctors to prescribe the drug. Sometimes by straightforward favor giving, sometimes by invitation to so-called research conferences, which were in actual fact golfing holidays of the kind — now what’s wrong with a golfing holiday aimed at M.D.’s, if we remember Sharon Oster? Do we remember? Yes.

Student: If I remember correctly, she said it was that if the doctor was willing to go on golfing holiday, that means the opportunity cost he’s losing is not that high, so it’s probably not a doctor that sees a lot.

Professor Douglas W. Rae: Okay, so the doctors with the lowest opportunity costs were going to Hawaii, go to Hawaii, and they’re not the people you’re trying to reach. That’s certainly true of the heart technology, maybe a little less true of Vioxx, where a very low key practice where you just casually advise people to take this drug would be very valuable.

Chapter 4. Common Law Tradition [00:25:43]

The common law tradition, the English common law is derived not from legislation but from cases, and builds up through precedent where each new case is analyzed by its analogy or lack thereof to earlier cases which raised the same legal issues. This tradition goes back a thousand years, or nearly a thousand years, and came to the United States with the immigrants who came to New England in the seventeenth century and is a dominant part of the American Legal Code, which is largely separable from Congress and the Legislative process. And central to it is the idea that courts should make the victims of careless, reckless, or fraudulent products whole; should make them — should bring them back to a situation as good as they would have been in if they had not received the bad product. Beyond that, often punitive damages, where if we say this person was harmed to the extent of $100,000 so we’d pay him the $100,000 at the expense of the company. We then say, this is a huge company, $100,000 means nothing to this company so let’s say $100 million. Most of the $100 million is punitive damage, which nonetheless goes to the victim, but is meant to teach the company a lesson. Well from the point of view of business, punitive damages are very scary. And the American legal landscape is a particularly complex one for that reason because with federalism, Ghen v. Rich, you remember it, Ghen v. Rich is about tort law, and about setting incentives in a way that works well for society as a whole, and the problem with Merck Vioxx is similarly that.

I’ll give you one more common law case to get the feel of this. At the close of World War II, the guy who owned this property near an airport sued the airport for the noise of planes going through his airspace. He said I own the airspace; they can only come through if they have my permission or pay me rent on the use of my airspace. The plaintiff had a very strong common law precedent. The common law theory of airspace was that you make a projection from the — after people were sure the world was round, it’s a spherical projection, to the ends of the universe, you owned everything that is in that spherical projection over your land. Now you were — you’re a judge, its 1947, the airline industry is just getting strong, and you’re presented with this case. Tal, how would you decide it?

Student: Well, since the airline industry is just getting strong I might want to incentivize them to keep flying and keep [inaudible] which would obviously be very difficult if I let every single person — it would obviously be very difficult to let the airline industry form if I let every single person who owns property control the airspace over their property because then they would have to — the transaction costs would be huge to negotiate with each and every single person.

Professor Douglas W. Rae: Absolutely. That nails the question. A flight — a little flight from Chicago to Milwaukee or from Milwaukee to Madison, Wisconsin or from Madison, Wisconsin to Minneapolis, would involve thousands of transactions and license fees with the owners of all the land you’re going to traverse, and the airline industry would be stillborn for that reason. In the background of this case, just as in the background of Ghen v. Rich, is creating incentives for those who are prepared to invest in the generation of value and ultimately of wealth for the society as a whole. Mr. Justice Douglas, in May of 1946, wrote the opinion in U.S. v. Cosby, which decided the case in favor of the airlines and against the landowners.

Chapter 5. The Plaintiff Bar and Mark Lanier [00:31:19]

Now the plaintiff bar — let’s not do the summaries. Let’s see if I can remember how we’re going to do this. DVD stage, play, this is a set of interviews we sent a — this is Mark Lanier: “I think Merck ultimately has to settle, maybe not all of the cases, but Merck certainly needs to settle the good cases. What Merck needs to do is wait until the statute of limitations runs. What that means is that there’s a time period after you’re damaged where you have to file your lawsuit, and if you don’t file within that time period your rights are gone. Merck needs to go ahead and wait and let that time period run, so that there is a fixed denominator, how many cases are out there, and then the numerator, how many of those is Merck going to settle, can be determined. I’m not sure that Merck needs to settle every case out there. These cases are expensive to fight and they’re hard to fight, and so Merck can satisfactorily settle the difficult cases of serious injury, where really I think all of us ultimately agree Merck owes the money, and then Merck can take those cases of lesser liability and ultimately tell the lawyers, ‘You want us, come get us.’ That’s where this has got to end up I think.”

I think there are probably about 25,000 to 30,000 cases that ultimately will be filed against Merck. Out of those 25,000 to 30,000 how many of them are good cases? I would guess probably — you’ve got different degradations of good. It’s like students, there’s A good and there’s B good, then there’s C not so good, and then there’s D and F, really not good at all. How many A/B cases in that grouping? Over half of them I think are probably A/B cases. How many of those are C’s? Maybe a third; how many of them are D and F? Maybe about 25%, I don’t know, my percentages may not add up, but it’s something in those ranges at least.”

My guess is $12 to $15 billion dollars for liability for Merck. I think if Ken Frazier, the general counsel for Merck, came to me and said, ‘Lanier here’s $12.5 billion dollars, make my headache go away,’ I could come pretty close to resolving all of his issues.” “There’s a great deal of difficulty in trying to set up a jurisdiction for hearing these cases. The way the law is set up, philosophically the plaintiff who has a burden of proof, the plaintiff has to prove their case, and a tie goes to the defendant if you will. The plaintiff with a burden of proof is supposed to get a pick of forum. By that it means if you’ve got to prove your case you should be allowed to choose in which court you want to do it. Realistically, in America, all of our courts are supposed to be fair, but practically, we recognize that some are more plaintiff friendly, and some are more defense friendly, and so the plaintiffs naturally try to find those courts that are plaintiff friendly.

The defendants want defense friendly courts. We tried the first case in Texas. Texas has a reputation for being plaintiff friendly, realistically I think at this point in time, it’s probably not. Our judge was appointed to the bench by George Bush when he was Governor of Texas. George Bush, President Bush, is certainly no friend to trial lawyers. We have an appellate court system in Texas that is entirely Republican. There will not be a Democratic judge that will ever see the Vioxx case we have, we tried in Texas, or the ones pending right now to my knowledge. In New Jersey you’ve got a different scenario. You’ve got a court system that’s very friendly, ideologically at least, with big pharma. Pharma has a home in New Jersey, has great tort reform in New Jersey, and until we got the punitive damage finding against Merck, had never been held responsible for punitive damages in New Jersey under the current state of the law.”

Professor Douglas W. Rae: If you Google “judicial hell-hole” you will find a map showing the most plaintiff friendly jurisdictions in the country. The huge ideological battle and political battle which is in progress, about federalizing and capping tort law awards, is out there. Just go “tort reform” or “judicial hell-holes” and you’ll get the flavor of it. Mark Lanier: “So New Jersey is somewhere that I think Merck would like — ” “The Harvard Business School slide that I’ve put was not the first slide I showed, but it certainly was in my opening statement. I wanted the jury to understand that when — before Ray Gilmartin came on board, Merck — which was 1994, Merck was run basically by a CEO named Dr. Vagelos and Dr. Vagelos is a world-renowned doctor, phenomenal doctor. When Ray Gilmartin came on board Merck didn’t hire a world-renowned doctor to run the company. Merck didn’t hire a world-renowned chemist, or even a nationally known chemist. Heck, I’d have taken a local chemist. They didn’t hire a pharmacist, someone who had experience with pills and medicines on even a local level, much less a national level. What Merck did is they took a different direction. They changed directions from the Vagelos days, Dr. Vagelos days, and they hired an MBA which I have a lot of respect for MBA’s, but I think we need to put into context what it was speaking to within the Merck culture. It was saying no longer is science running our company, we’re now going to run this company along economic terms as a business, and Ray Gilmartin came in, as a Harvard trained MBA, who had really no science background whatsoever. It was an — I put the Harvard Business School slide up to put a visual image to go with the intellectual concept that Merck was choosing to be a business first company not a patient — “

When we tried the Ernst case, I was stunned at the opening that Merck gave. Understand Bob Ernst died from what’s called sudden cardiac death. Sudden cardiac death means you are dead by the time you’re in the hospital and the cause is not something they can easily trace, but it’s clearly a heart problem. The sudden cardiac death was attributed to an arrhythmia, which is a ventricular fibrillation for him, his heart was quivering, and the question ultimately becomes, what caused that heart quivering arrhythmia? Most typically, according to the Merck Manual, it’s caused by a heart attack, but it can be caused by an electrocution, it can be caused by inhaling a lot of salt water in a drowning, and it can be caused by being exposed to hypothermia.

Clearly none of those is what had happened to Bob Ernst. Bob Ernst had had a heart attack. I was stunned in opening when the Merck lawyer stood up and told the jury, disingenuously I believe, that if the jury looked at the coroner’s report they would see that they coroner said Bob Ernst had not had a heart attack, Bob Ernst had died from arrhythmia secondary to arthrosclerosis. Well, those are both caused by a heart attack. Someone may have died from a loss of blood okay, but if someone was shot, and it was the gunshot that caused the bleeding and the loss of blood, it’s disingenuous to stand up and tell a jury, well they didn’t die from the bullet, they died from loss of blood.”

I was shocked by that because I thought it was a misrepresentation, and I think Merck did it thinking they could get away with it because no one had ever been able to find the coroner and ask her what she meant, and so I don’t have any testimony to the contrary, we just have a report. I went back to my office and I said, ‘I want the coroner.’ And they said ‘We can’t find the coroner.’ I said ‘We can find anybody except Bin Laden, find the coroner.’ We hired a couple of PI’s, we found the coroner doing pathology work in the United Arab Emirates Abu Dhabi. I shot her an email asking her if she would mind if I spoke with her. She emailed back and said she’d be glad to speak with me. I called her on the phone and I said, here is what was said about this case in opening, here is what your autopsy said, tell me about it. She said ‘Well he died, under an autopsy I have to put the physical cause, physical cause it was a sudden cardiac death with an arrhythmia, secondary to arthrosclerosis.’ I said ‘Well how does that kill you’? She said ‘Easy, you have a heart attack.’ I said ‘Really?’ She said ‘Of course, that’s the only thing that causes it. Arthrosclerosis causes a heart attack; the heart attack causes an arrhythmia.’ She said ‘Unless he was electrocuted,” she said ‘Was he electrocuted?’ I said ‘No.’ She said ‘Okay.’ I said ‘Would you come over and explain that to the jury?’ She said ‘I would be glad too,’ so she came over. Well Merck threw a fit because Merck says we never would have told the jury what we did if we’d known Lanier was going to be allowed to tell the truth about it.”

Professor Douglas W. Rae: That film is almost an hour long. We had it made for the MBA’s a couple of years ago. Mary Pat, you’re not the coroner but if I asked you, is there — is another set of relationships that involve Merck, that were behind the scenes in all this, and what you know about it, help me out.

Student: Sure. Well in addition to all the plaintiffs who brought cases against Merck, Merck also had taken out insurance policies for product liability and liability exposure insurance, and they took them from a bunch of companies like Munich Reinsurance and at the same time that all these cases were going on, Merck was trying to collect on those policies. Basically they wanted money because they had to pull Vioxx and all the exposure, they were losing a lot of money in profits that way. These insurance companies were saying, “Well you are exercising a breach of warranty, because when you took out these policies you basically told us that this sort of a thing wouldn’t happen, but we’re saying that you knew something like this would happen.”

Professor Douglas W. Rae: Did the company your close relative represented end up paying or not?

Student: They paid some of the damages but not all.

Professor Douglas W. Rae: Some sort of a negotiated settlement?

Student: Yeah.

Professor Douglas W. Rae: Let me finish this. The ultimate outcome was a negotiated settlement amounting not to $12.5 billion dollars as Mark Lanier thought or claimed to think, but $4.85 billion. What happens is the Court system creates a class action suit and then settles the class action suit in a way which creates a scoring system for the plaintiffs, the tens of thousands of plaintiffs. The score you get depends on how long you used the drug, and how severely you suffered, and how plausible the causal connection between what happened to you and the drug is. For example, if you took Vioxx for a short period of time but were a 280 pound diabetic, with a major smoking problem, and a quart a day bourbon problem, the odds were that you weren’t going to get a lot of money out of the settlement, so it’s a mechanical system. And I personally believe that when used within reasonable limits common law is a way of protecting relatively small people against large companies. The adjudication of that boundary, which is now in progress, is very important. The killer for large companies is the transaction costs of settling so many cases can themselves be prohibitive. Okay, exam on Wednesday and back to work on Monday.

[end of transcript]

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