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Oklahoma Firefighters Pension & Ret. System v. Ixia, a Corp.

United States District Court, C.D. California

October 6, 2014

OKLAHOMA FIREFIGHTERS PENSION & RETIREMENT SYSTEM and OKLAHOMA LAW ENFORCEMENT RETIREMENT SYSTEM, individually and on behalf of all others similarly situated, Plaintiffs,
IXIA, a corporation, VICTOR ALSTON, an individual, ATUL BHATNAGAR, an individual, THOMAS B. MILLER, an individual, and ERROL GINSBURG, an individual, Defendants

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For Oklahoma Firefighters Pension & Retirement System, Individually and on Behalf of Other Persons Similarly Situated, Oklahoma Law Enforcement Retirement System, Individually and on Behalf of Other Persons Similarly Situated, Plaintiffs: Jeff S Westerman, LEAD ATTORNEY, Anna Faircloth, Westerman Law Corp, Los Angeles, CA; Caitlin M Moyna, James J Sabella, PRO HAC VICE, Grant and Eisenhofer PA, New York, NY; Diane Zilka, John C Kairis, PRO HAC VICE, Grant and Eisenhofer PA, Wilmington, DE.

For Ixia, Defendant: Bradley James Dugan Bryan Cave LLP, Santa Monica, CA; Eric Rieder, Ronald J Bliss, PRO HAC VICE, Bryan Cave LLP, New York, NY.

For Victor Alston, Defendant: Christopher G Caldwell, LEAD ATTORNEY, Benjamin B Au, Julia Jill Bredrup, Caldwell Leslie and Proctor PC, Los Angeles, CA.

For Atul Bhatnagar, Thomas B Miller, Errol Ginsberg, Defendants: Sheldon E Eisenberg, LEAD ATTORNEY, Adam J Thurston, Alexandra N Burgess, Erin E McCracken, Drinker Biddle and Reath LLP, Los Angeles, CA.

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This is a putative securities class action against defendant Ixia and defendants Victor Alston, Atul Bhatnagar, Thomas B. Miller, and Errol Ginsburg (the " individual defendants" ). Plaintiffs allege that during the class period, defendants misled the public by improperly classifying Ixia's revenue. They assert that defendants sought to portray Ixia, which was exceeding its revenue and earnings per share targets during the class period, as a steady growth company. They contend that to foster this image, Ixia did not record certain present revenue and instead booked it as deferred revenue to give the impression that the company would continue to grow at an attractive rate in future quarters. Plaintiffs contend this misled inventors and caused them to conclude that Ixia's growth would continue for some period of time.

They assert that by making these misleading statements, defendants violated section 10(b) of the Securities Exchange Act of 1934 (the " 1934 Act" ) and Securities and Exchange Commission (" SEC" ) Rule 10b-5 during a class period that extended from November 28, 2007 to August 17, 2010. They also assert that defendants Victor Alston, Atul Bhatnagar, Thomas B. Miller, and Errol Ginsburg violated § 20(a) of the 1934 Act because they were controlling persons of Ixia.[1]

On June 11, 2014, plaintiffs filed a first amended complaint.[2] Defendants filed various motions to dismiss on July 18, 2014.[3] Plaintiffs filed omnibus opposition on August 18, 2014.[4]


A. Background Concerning Ixia, the Individual Defendants and the Plaintiff Class

Ixia was incorporated in California in 1997 and maintains its headquarters in Calabasas.[5] Ixia's core operations focus on delivery of information technology solutions to a wide array of organizations through real-time monitoring and rapid assessment of network systems. Its products are used to provide " end-to-end visibility" -- a more complete understanding of user behavior, security vulnerabilities, network capacity, application performance, and information technology resiliency.[6]

Ginsburg founded Ixia in 1997; he has been chairman of its board of directors since January 2008 and chief innovation officer since March 2008.[7] Alston joined

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Ixia in 2004 as vice president of application development. In 2006, he was promoted to vice president of engineering, and in June 2007 to senior vice president of product development. Alston became president and chief executive officer of the company in May 2012, and served in that capacity until his resignation on October 24, 2013.[8] Bhatnagar was hired as Ixia's chief operating officer on September 4, 2007; he served as president and chief executive officer from March 2008 until Alston assumed the position in May 2012.[9] Miller served as Ixia's chief financial officer from March 2000 to March 3, 2014.[10]

Plaintiffs allege that each of the individual defendants had authority to control the contents of Ixia's quarterly reports, annual reports, press releases, and presentations to securities analysts, money and portfolio managers, and institutional investors.[11] Each of the individual defendants allegedly " received copies" of Ixia's press releases and reports " prior to or shortly after their issuance," and each purportedly " had the ability and opportunity to prevent their issuance or cause them to be corrected." [12] Plaintiffs contend that, as a result of their positions at Ixia, and their access to material nonpublic information, the individual defendants knew that the adverse information detailed in the complaint had not been publicly disclosed and was being concealed. As a result, each allegedly knew that the representations being made by the company were false and misleading.

Plaintiffs are public pension retirement funds that allegedly acquired shares of Ixia at artificially inflated prices during the class period and that have been damaged as a result.[13] They bring this class action on behalf of all persons who purchased or otherwise acquired Ixia's publicly traded common stock from February 4, 2011 to and including April 3, 2013.[14]

B. Defendants' Allegedly Fraudulent Scheme

Plaintiffs allege that Ixia's common stock began to trade publicly on the NASDAQ on October 25, 2000.[15] Analysts viewed Ixia as a growth company in 2004 and 2005, and the price of its stock rose steadily from approximately $11 per share in early 2004 to more than $16 per share by the end of that year. The share price continued to rise in 2005, as the stock trade in the high teens for the first half of the year and above $20 at some points during the second half of the year.[16] Ixia's growth began to slow at the end of 2005. Plaintiffs allege that at this point, investors lost their enthusiasm for the stock, which declined in value to roughly $10 per share by the end of November 2005.[17] Ixia's stock price languished in the mid-single digits for the next several years. Miller admitted during a December 4, 2012 conference call that the Ixia was " in a little bit of a rut."

Plaintiffs allege that, as Ixia's stock fell out of favor with investors, the company was forced to restate the way it recognized its software service and warranty contracts. On February 23, 2007, Ixia purportedly

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announced that it was restating its Forms 10-K for the years ended December 31, 2003, 2004, and 2005, as well as Forms 10-Q for quarters ended March 31, 2006 June 30, 2006, and September 30, 2006 (the " 2007 restatement" ).[18] The restatement adjusted revenues, operating results, and deferred revenue because Ixia had recognized too much present revenue from the contracts, and should have deferred a portion of it as required by applicable accounting rules.[19] Miller and Alston were high ranking Ixia officers at the time, and Ginsberg was the company's founder; Bhatnagar joined the company as its COO a few months after the 2007 restatement.[20]

Plaintiffs contend that the decline in Ixia's stock price occurred largely because it had fallen out of favor as a technology " growth" company.[21] By way of example, they allege that in a May 1, 2010 analyst report, Price Target Research noted that " Ixia's growth rate has slowed very considerably in recent years. Annual revenue growth has been 10.6% per year. Total asset growth has been 9.6% per year. (More recently it has been 0.7%). Annual [earnings per share] has been 7.1% per year. Equity growth has been 7.3%. (More recently it has been -6.7%)." [22] Plaintiffs assert that as a result of this lackluster performance, Ixia sought to " reinvigorate investor enthusiasm and drive up the price of its common stock by convincing the public that it was once again a 'growth' company." [23] To accomplish this, Ixia purportedly employed a variety of unlawful methods, including: " (1) improperly inflating [its] deferred revenues -- a common indicator of a Company's growth prospects -- in violation of [Generally Accepted Accounting Principles (" GAAP" )], so that investors would believe that Ixia's growth would continue into future quarters; (2) promoting Alston to the position of CEO because Ixia's board believed his reputation for being 'aggressive' would accelerate Ixia's growth prospects; and (3) acquiring niche businesses engaged in growth areas." [24]

1. Ixia's Focus on Future Growth Potential

Plaintiffs allege that Ixia began to focus on future growth potential after it strategically acquired two small businesses in 2009[25] -- Catapult Communications, which designs, develops, manufactures, markets and supports software-based test systems for the telecommunications industry, on June 23, 2009, and the N2X product line from Agilent Technologies for $44 million in cash on October 21, 2009.[26] These acquisitions allegedly piqued the interest of the investment community. On May 19, 2010, Wunderlich Securities reported that data center and core routing product cycles ensured a growth cycle for one of Ixia's newly acquired products. Price Target Research noted on June 6, 2010 that Ixia's growth rate forecast was 20% -- " substantially above the average historical growth measures." It also observed, however,

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that Ixia's growth rate " ha[d] slowed very considerably in recent years." [27]

Plaintiffs cite numerous other analyst reports from 2010 that focused on Ixia's potential for growth. They note that Morgan Keegan & Co. reported that " Ixia's growth rates of 46% in 2010 (boosted by acquisitions) and 15% in 2011 compare[d] to its test & measurement end market growth rates of 18% and 21% in our estimates, which suggest[ed] that [the] estimates [were] conservative with room for upside." [28] Wunderlich reported on October 22, 2010 that it was " increasing [its estimate of Ixia's] 3-5 year growth rate to 22% from 20%." [29] Capstone analysts met with Ixia management in November 2010; Capstone reported on November 11, 2010, that management " talked about the industry trends providing tailwinds for their product growth," and noted that Wall Street " estimates [were] currently for 16% and 12% [year over year] sales growth for 2011 and 2012." [30] Finally, on November 23, 2010, Wunderlich reported that it believed " most of the upside of Ixia's recent results and guidance represent[ed] the early stage of a demand cycle that [would] be lengthier and larger than what the company had previously experienced, because demand for data ha[d] multiplied . . . and [was] expanding into emerging markets." Wunderlich increased its 3-5 year net income growth rate forecast for Ixia from 22% to 28%.[31]

Plaintiffs allege that during the period Ixia was " building its story as a growth company," analysts were paying close attention to its deferred revenues, and in particular its ability to generate service-based or other types of renewable, recurring revenue.[32] They contend that investors often view deferred revenues as an indication of a company's future health and ability to grow. They cite a May 9, 2010 report by Wunderlich, which stated that it " expect[ed] continued strong software and service maintenance renewals," [33] and a July 21, 2010 analyst report in which Wunderlich commented on Ixia's deferred revenues, stating: " Recent growth in deferred revenue adds visibility. Deferred revenue grew 10.5% sequentially in the March quarter, well ahead of the 2.4% sequential growth we forecast for both product and service revenue." [34] Plaintiffs also note Wunderlich's comment that " Ixia saw little of the service revenue that contributed over 30% of [Catapult's] sales when [it] was an independent company. Much of this was because of the elimination of deferred revenue through acquisition accounting. . . ." Wunderlich reported, however, that it " expect[ed] visibility for maintenance renewals to have improved." [35] Indeed, during a July 22, 2010 analyst conference call, a Wunderlich analyst asked whether Ixia expected the maintenance revenues Catapult had typically earned as an independent company to come back. Miller responded that he believed they would, because the rate of renewals was essentially unchanged, and Ixia would be able to recognize 100% of the renewal revenue that it was initially

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unable to recognize because of post-acquisition accounting requirements.[36] Plaintiffs assert the analyst's question shows that the market was concerned that Ixia's revenues were too dependent on product-based revenues as opposed to renewable maintenance and service-based revenues.[37]

Wunderlich purportedly continued to focus on deferred revenue for the rest of 2010 and into 2011. During a February 3, 2011 analyst call, a Wunderlich analyst noted that Ixia had " good deferred revenue growth, along with activity decrease in [day sales outstanding]." In response, Miller commented that Ixia was a " very back-end loaded business." The next day, Wunderlich reported that Ixia's " deferred revenue grew the most in a year and [day sales outstanding] declined to the lowest level in more than a year." Specifically, it reported that deferred revenue was up 11.9% -- " the strongest sequential comparison since the 4Q09 N2x acquisition." [38]

Plaintiffs contend that Deutsche Bank also " bought in" to Ixia's growth story; it observed in a February 3, 2011 report that although Ixia was trading at a premium in comparison with its peers, the premium was " merited by [Ixia's] leadership position in the test equipment market and by the current network upgrade cycle." [39] Deutsche Bank also stated that Ixia continued to benefit from " several growth trends," including consolidation of data centers, a shift toward cloud-based computing, and growth in mobile data.[40]

2. Allegations of Fraudulently Inflated Deferred Revenue in Quarterly and Annual Reports

Plaintiffs contend that simply acquiring new businesses was not sufficient to permit Ixia to grow. They assert that at some point during 2010, Ixia began fraudulently to inflate its deferred revenue to convince investors of its capacity for sustained growth, and that it continued the practice throughout the class period.[41] Plaintiffs contend that on April 3, 2013, Ixia announced that deferred revenues had been inflated throughout the class period, and that its Audit Committee had recommended that it restate previously issued financial statements (" the first restatement" ).[42] Ixia's Form 10-K for 2010, which was filed February 3, 2011, is the earliest of Ixia's public statements that was restated. In it, Ixia reported total revenue of $276.8 million, an increase of 56% from the prior year, and deferred revenue of $46.7 million for the year 2010.[43] The restatement revealed that deferred revenues had been artificially inflated, and total revenues deflated.[44] Plaintiffs allege that had Ixia properly accounted for deferred earnings, it would have reported an additional 14% increase in net income. Although Ixia reported that the restatement " affect[ed] . . . deferred revenues," it did not state how much deferred revenue for 2010 had been inflated.[45]

On April 21, 2011, Ixia held an analyst call to announce earnings for the first quarter of 2011. It reported that revenues

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had exceeded expectations, growing to a record $78.5 million; in addition, it reported deferred revenue of $45.2 million.[46] The first restatement allegedly later revealed that deferred revenues were artificially inflated.[47] Had correct revenue figures been used, Ixia's net income would allegedly have declined by $.472 million, from $7.1 million to $6.6 million. Once again, Ixia's restatement did not reflect the amount by which deferred revenues for the first quarter of 2011 had been inflated.[48]

During the April 21 conference call, Ixia allegedly continued to encourage investors to view it as a growth company. Then-CEO Bhatnagar stated that Ixia was " excited about [its] market positioning, as well as the opportunities [it] [saw] for future growth and global expansion." [49] He also purportedly told a Deutsche Bank analyst that the company continued to expect growth of 15-20% in its core businesses.[50] Deutsche Bank later highlighted the fact that Ixia " made a point to say [that it had] the ability to grow both organically and inorganically." [51] Capstone also focused on Ixia's growth, remarking that Ixia " may be growing faster than the market, as well as gaining additional revenue cross selling other products to its existing customers." [52] Plaintiffs allege that Ixia continued to promote its story of growth by acquiring VeriWave, a privately held wireless LAN testing equipment company, on June 27, 2011.[53]

On July 6, 2011, Ixia purportedly announced ahead of its earnings report that it expected to miss expectations for the second quarter of 2011.[54] Ixia's stock price fell 24% from a closing price of $13.01 on July 7, 2011 to $9.90 on July 8, 2011.[55] Capstone questioned whether this was merely a " road bump or [a] major detour" on July 8. Wunderlich noted in a report the same day that Ixia " [did] not benefit from the flywheel effect of a strong subscription revenue base," because " more than 80%" of its revenue came from product sales.[56] Plaintiffs assert these analyst comments increased the pressure on Ixia to paint a positive picture of its capacity to generate recurring revenue from subscription-based services like maintenance.[57] Thus, on July 21, 2011, after the close of trading, Ixia reported total second quarter 2011 revenue of $69 million, down from the prior quarter, and record deferred revenues of $49.9 million, up 10.3% from the first quarter of 2011, and 22.7% from the second quarter 2010.[58] Ixia's stock price remained relatively unchanged after the substantial loss caused by the pre-announcement that Ixia had missed its earnings guidance.[59] Plaintiffs allege that the deferred revenue reported was inflated, and was subsequently adjusted in the first restatement.[60] In particular, they assert

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that Ixia should have reported an increase in net income, and diluted earnings per share of $.02 cents instead of $.01 cents.[61] The first restatement did not report how much deferred revenue had been overstated; it simply noted that the restatement " affect[ed] . . . deferred revenues." [62]

Miller and Bhatnagar also allegedly made statements focusing on deferred revenue during this period. During a conference call on July 21, 2011, Miller allegedly stated that there were deals Ixia hoped to pull out of deferred revenues in the next quarter; plaintiffs assert his statement served to reinforce investors' belief that deferred revenues were an indicator of the company's future success.[63] Bhatnagar said he believed there was more room for growth; he stated that wireless traffic was doubling and that, that, despite the potential for a " blip" here and there, Ixia was poised for " very solid growth" over the next three to four years.[64] Plaintiffs allege these statements were an attempt to convince investors that Ixia would have solid, sustainable, and overall smooth growth. Following the conference call, Deutsche Bank reported on July 22, 2011 that management had reassured investors that the company's business trends were intact and that the major technology transitions relevant to its core operations still had momentum. Plaintiffs assert Ixia's announcement of high deferred revenues defrayed analysts' concerns following the negative earnings announcement.[65] They note Wunderlich reported that the decline in revenues " was a function of . . . deferred revenue growth, which was up 22.7% [year over year] and 10.3% sequentially; this was well more than the $0.16 per share of earnings that was expected before the preannouncement" of a negative quarter.[66]

On October 20, 2011, Ixia held an analyst call to report third quarter 2011 earnings.[67] It stated that revenue had increased to $77.3 million, " at the higher end of [the] guidance," reflecting 9% year-over-year growth compared with the same quarter in 2010.[68] It also reported deferred revenue of $49.2 million -- an 18% increase from the third quarter of 2010.[69] Wunderlich and Capstone greeted this information enthusiastically. Wunderlich reported that the " June quarter miss look[ed] like a hiccup instead of a heart attack," while Capstone stated that the " Q2 miss appear[ed] . . . to be short lived." [70] Plaintiffs allege that in reality, the company's deferred revenue was artificially inflated, as the first restatement later revealed.[71] Even after restating its financials, they charge, Ixia did not report the amount by it had overstated deferred revenue.[72]

They assert that the first restatement confirmed that Ixia's inflation of deferred earnings continued into the fourth quarter of 2011.[73] Ixia reported deferred revenue for the fourth quarter of $51.1 million -- up

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9.4% from the same quarter in 2010.[74] It also reported total revenue for fiscal 2011 of $308.4 million, an increase of 11%.[75] These revenues and the company's earnings per share exceeded guidance and analyst expectations.[76] Ixia's stock rose 14% on this news, from a close of $12.74 on February 2, 2012, to a close of $14.55 on February 3, 2012.[77] Plaintiffs contend, however, that once again, the numbers were artificially inflated and would be corrected in the first restatement.[78] Deferred revenues for the fourth quarter should only have been $43.02 million -- 18.7% lower than the number reported. Plaintiffs allege this was done to mislead investors and cause then to believe that Ixia was a growth company due at least in part to recurring revenue streams.[79] They maintain that, properly reported, total net income for the fiscal year would have increased by $2.9 million, from $23.8 million to $26.7 million.[80]

On March 15, 2012, Ixia announced it was replacing Bhatnagar with Alston, effective May 1, 2012.[81] Alston was allegedly instrumental in defining Ixia's strategy and identifying acquisitions; replacing Bhatnagar with Alston was purportedly a move intended to further enhance investor perceptions of Ixia as a growth company.[82] Wunderlich expressed surprise, but noted that Ixia's board saw potential for " even speedier execution with Alston in charge." [83]

On April 19, 2012, Ixia announced total revenue of $85.6 million for the first quarter of 2012; it also reported deferred revenues of $57 million.[84] Ixia's stock rose 9.1%, closing on April 19, 2012 at $11.21, and the following day at $12.23.[85]

Deutsche Bank noted that Ixia had beat analysts' consensus number of $83.5 million; Gabelli & Company, Inc. observed that the company's solid growth trend was expected to continue; and Wunderlich remarked on Ixia's " strong balance of deferred revenue [which could] diminish[ ] head-line risk for the current quarter." [86] Plaintiffs allege that Ixia's deferred revenue was inflated, as the first restatement later revealed that deferred revenue for the first quarter of 2012 should have been $47.9 million, 18% less than the $57 million initially reported. Net income should purportedly have been $5.2 million -- an increase of 15.2%.[87]

Plaintiffs also allege that Ixia made two more acquisitions in 2012. On May 4, 2012, it announced that it acquired Anue Systems, Inc. for $154.4 million, and on July 2, 2012, it announced that it acquired BreakingPoint Systems.[88] Plaintiffs assert that while these acquisitions may have signaled to investors that Ixia wanted to grow, it was the deferred revenue it reported that provided " factual and quantifiable

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evidence" that it could grow. Absent the reporting of inflated deferred revenue, plaintiffs contend, the acquisitions alone would not have convinced investors that Ixia was a growth company.[89]

Ixia purportedly continued to report inflated deferred revenue during the remainder of 2012. On July 26, 2012, it announced second quarter results. These included revenue of $92.3 million and deferred revenue of $62.5 million, up 9.8% from the prior quarter, and 25.3% over the same quarter in 2011.[90] Plaintiffs assert that analysts were " generally pleased" with these results, commenting that the company's " [g]rowth [did] not appear to be slowing," that it had provided full year guidance for 2012 and 2013 that " reiterate[d] [its] belief in [its] growth prospects," and that management was " optimistic" about the company's growth trajectory for 2012.[91] The first restatement, however, later revealed that deferred revenue had once again been inflated, and that it should have been $55.1 million or 13.4% lower.[92] They also assert that actual revenue was overstated, and that, had the correct revenue figure been used, the company's net income would have declined by $1.2 million.[93]

Ixia announced third quarter 2012 results on October 24, 2012. It reported revenues of $109.6 million, and record deferred revenues of $76.8 million -- up 22.8% from the prior quarter, and 56% form the third quarter 2011.[94] Plaintiffs allege these figures were false and misleading because the first restatement revealed that Ixia's deferred revenues were actually only $68.3 million, or 12.4% lower than the $76.8 million they initially reported.[95] Net income also would have declined by $0.5 million, from $11.4 million to $10.9 million, if properly accounted for.[96]

On February 6, 2013, Ixia announced yet another record breaking quarter. It reported that fourth quarter revenue was $124 million, up 48% from the same quarter in 2011.[97] Ixia noted that its " core businesses" had generated record revenue -- up 12% from the prior year and 16% for the year.[98] It also reported deferred revenue of $74.8 million -- up 46.5% from the fourth quarter 2011. Plaintiffs allege that the first restatement later revealed that this figure had been artificially inflated, although it did not provide the correct amount.[99]

3. Misstatements Concerning Internal Controls

Plaintiffs also allege that Ixia made misstatements concerning its internal controls. Specifically, they allege that Ixia made the following statement in each Form 10-Q that it filed during the restated periods:

There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter . . . that have materially affected, or are reasonably

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likely to materially affect, our internal control over financial reporting.[100]

Plaintiffs assert this statement was materially false and misleading because Ixia announced on April 3, 2013, as discussed in more detail infra, that there had been material weaknesses in its internal controls over revenue recognition related to software maintenance and warranty contracts.[101] They contend Ixia's 2010 and 2011 Forms 10-K were also false and misleading, in that they represented management had concluded that the company's internal controls over financial reporting were effective as of December 31, 2010." On April 3, 2013, however, Ixia acknowledged that there were material weaknesses in its internal controls. It stated that " the Company [had] not maintain[ed] effective disclosure controls and procedures and internal control over financial reporting as of December 31, 2012 because of . ...

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