Vulgarians at the Gate How ego, greed, and envy turned MedPartners from a hot stock into a Wall Street fiasco.
(FORTUNE Magazine) – Some industries just seem naturally to become magnets for greedheads and promoters. In the 1970s it was real estate. In the 1980s, S&Ls. And for a brief stretch this decade, it was the business of physician-practice management. It was a new kind of business but an old, familiar pattern: Confident entrepreneur pitches his company as the next sure bet, persuading thousands to hand over their dimes with the promise of turning them into dollars. A period of euphoria follows, when the business seems to be taking off like a rocket; the principals travel in corporate jets and limousines and behave like masters of the universe. And it all turns out to be an exceedingly painful illusion, as the impresario proves far better at lining his own pockets than at running a real business. This profile perfectly describes a Birmingham, Ala., company called MedPartners, a onetime Wall Street darling that has cost investors billions and given about 13,000 American doctors nightmares. The particulars of the ride are wild--and, to those considering sinking their savings into The Next Big Thing, might serve as a cautionary tale. This is also a case study of a business friendship gone awry--of envy, pride, and insecurity in dangerously high places. It was the remarkable success of one Birmingham good ol' boy, Richard Scrushy, that made it possible for another, Larry House, to build a FORTUNE 500 company--then slam it into a wall. The MedPartners story is largely the spectacle of these two CEO hustlers--one colorful, one bloodless; one focused, one obsessed; one totally in command, one hopelessly out of his depth--vying for the status of top dog. Their contorted relationship turned a promising enterprise into one of 1998's biggest Wall Street fiascos. We're in Birmingham, at the home of a $4 billion company called HealthSouth, and the scent of Elvis is in the air. HealthSouth is the creation of a 46-year-old Wall Street hero named Richard Scrushy, and not unlike Graceland, it's a place positively reeking of self-worship and control. The HealthSouth complex, which sits atop a hill on the company's 74-acre corporate campus, has been built to the boss' detailed specifications. At the rear of the enormous headquarters lobby is a Richard Scrushy museum. There, preserved behind glass, are the childlike poster-paper scrawlings--depicting men pulling a wagon--that Scrushy used to rally his staff around his concept for building a national chain of outpatient clinics to treat orthopedic injuries. There, on a wall, is the company's first lease, signed by Scrushy. And there, behind museum rope, as a plaque explains, "the Board Room and Office of the Chairman is exactly as it was in 1984 when Mr. Scrushy founded the company"--down to photos of the kids on the credenza and a personalized HealthSouth coffee mug on the desk. On the conference table is a book with a cover that reads How I Changed the Rehab Industry, by Richard M. Scrushy. Flamboyant, natty, carefully tanned, Scrushy is almost a caricature of the modern swashbuckling CEO. He often pilots his company jet, he has cut a CD with his own honky-tonk band, and he promotes HealthSouth by hobnobbing with celebrity ex-jocks like Bo Jackson. In 1997 his pay, including cashed-in options, totaled $106.8 million. When Scrushy married his third wife in 1997, he chartered a plane to fly 150 guests to Jamaica and hired Bob Marley's widow to perform. (In a letter accompanying the invitation, he cast the occasion as a lesson in social consciousness, writing: "The poverty of this Third World country allows us to realize how blessed we are....") In Birmingham, where he is often referred to as King Richard, Scrushy doomed his own scheme to build a big-league sports stadium by telling a journalist he had the backing of "the little people." Like his departed Memphis counterpart, Scrushy also has real talent. A former respiratory therapist, he has built HealthSouth into the dominant "rehabilitation services" company in the country, with nearly 2,000 outpatient clinics, day-surgery offices, imaging centers, and rehab hospitals. Operating in all 50 states, the company now commands nearly 70% of the rehab market, offering one-stop shopping for workers injured on the job and sidelined yuppie sportsmen. Applying the McDonald's approach to twisted knees and wrenched backs was a big idea, to be sure. But Scrushy also has executed brilliantly. He is known as a taskmaster and a micromanager, traits that are practically requirements for running a modern health-care company. In HealthSouth's first eight years Scrushy honed his technique, opening one clinic after another and centralizing every piece of data imaginable. Every Friday a stack of printouts detailing the performance of each facility landed on his desk; when any one of them had a problem, Scrushy pounced. Then in 1992, with 145 clinics and $400 million in revenue, Scrushy became a dealmaker, quickening the company's rate of growth. Buying out competitors and branching into related businesses, Scrushy skillfully digested the people and facilities that fit into his system--and spat out the rest. His timing was ideal: HealthSouth capitalized shrewdly on the push to cut health-care costs through efficient outpatient clinics. Wall Street loved it. Top fund managers loaded up on HealthSouth stock, which rose at an annual rate of 31% between 1987 and 1997. And Scrushy did what he could to sustain the momentum. He rarely missed an investment conference; last year he flew into a blizzard for one at a Utah ski resort. He handled much of his company's investor relations personally. Most important, Scrushy always made it a point to meet or beat Wall Street's earnings expectations. All this made Scrushy a man to see when a hot new idea in the business of health care came along. That, of course, is just what happened in the early 1990s, when the industry dedicated to managing doctors' clinics--physician-practice management companies, known as PPMs--began to emerge. Viewing the wreckage from a distance, one can easily see how this opportunity seemed huge at the time. The nation's 600,000 doctors billed more than $200 billion a year--and directed, through referrals, another $600 billion. Yet they still operated like a cottage industry, with more than three-quarters practicing in groups of fewer than ten. And in the early 1990s doctors--independent-minded as a rule--were in a collective panic. The big HMOs were driving down physicians' fees; costs were rising; and Hillary Clinton was threatening to reshape the health-care landscape. This made doctors receptive to the idea of joining a big management company that could both increase their bargaining clout and free them from the administrative burdens of running a practice. An early PPM company called PhyCor, formed in 1988 and based in Nashville, was already blazing the trail. In 1992, shortly after PhyCor launched a successful IPO, HealthSouth was approached by a young entrepreneur who wanted to start a PPM. HealthSouth provided the first $1 million in seed money to launch MedPartners. Scrushy lined up the venture capital funding, invested his own money--making him one of the biggest shareholders--and agreed to serve as a director. Scrushy was a master at precisely the skills PPMs required--dealmaking, creating efficiencies, running things through a centralized staff--but there was one big problem: He had his own company to run. Unwilling to entrust the top job to the entrepreneur, Scrushy and the venture capital firms came up with the next-best thing to a company run by Richard Scrushy: a company run by a disciple of Richard Scrushy's. He came, of course, from HealthSouth. Larry Ray House, then 49, had worked for Scrushy for almost a decade, most of that time as the company's chief operating officer. He served on the HealthSouth board. And like Scrushy, he was a former respiratory therapist. The original game plan was simple: MedPartners would exploit the Scrushy-HealthSouth halo--and connections--to grab a piece of the PPM action. And the new company would feed patients into HealthSouth's rehab network, helping to bolster the earnings of the larger, better-known company. But Larry House had other ideas. As Scrushy now puts it: "Larry didn't want to work under me or anybody else. He was wanting to go out and slay his own dragons." The trouble was, Larry House lacked the skill to be a Scrushy clone--and he was unwilling to be a Scrushy puppet. The two men could hardly have been more different. Where Scrushy invariably commanded a room, House, frumpy and overweight, melted into a crowd. Scrushy worked smart; House, nine years older, worked into the night. Scrushy was Birmingham's King Richard; though few people knew it at the time, House had already failed once in business. After MedPartners was founded, House explained in press interviews that he was qualified to run it partly because he had come to HealthSouth after building, then selling, his own business. What he didn't say--and what is revealed in Alabama court records--was that the experience hadn't been pretty. House's privately held Birmingham company, American Intermedical Resources (also called AIR Inc.), provided contract respiratory services to hospitals. Founded in 1975, the company eventually employed 500 people. But after government reimbursement rates for these services were cut, the business faltered. House and AIR Inc. were hit with lawsuits and court judgments. (All have now been resolved.) One creditor even won an order to garnishee House's salary at HealthSouth. House's lawyer denies today that the business was a failure, but in 1989, during sworn trial testimony in an IRS suit to collect back taxes, penalties, and interest from him, House recalled his company's demise: "I was broke...I lost my house, I lost everything I had.... I was unable to make payroll...so it gradually went down the tubes." (House, says his attorney, is bound by a legal agreement not to comment publicly.) After AIR failed, Richard Scrushy--an old industry acquaintance--rescued House, bringing him into HealthSouth, then just a year old, in 1985. Starting out on a 90-day contract for a marketing project, House worked his way up the ranks. House may have been grateful, but by the time the MedPartners idea came along, he was chafing. "Larry hated being in Richard's shadow," says one early MedPartners investor. Indeed, among people who knew both men, it was often noted that House seemed to suffer from a "Scrushy complex." House was never going to be able to match Scrushy for charisma or showmanship. But when he was put in charge of MedPartners, House had his chance: Running his own company, he could make it bigger than Scrushy had made HealthSouth, and build it faster. He could out-Scrushy Scrushy. And that's what he seemed bent on doing. MedPartners' original business plan had envisioned a small company, with $83 million in annual revenues and 105 physicians under contract after five years of operation. But its CEO had other ideas. House led MedPartners on an incredible binge. It took the company just one year to go public; just two years to double its stock; just three years to hit the FORTUNE 500; and just four years to top $6 billion in annual revenues. Claiming the role of industry "consolidator," MedPartners, by affiliating with more than 13,000 doctors, raced past PhyCor to become the nation's largest PPM. PhyCor played tortoise to MedPartners' hare, with a strategy that seemed to make sense--particularly in an untested industry. It steadily gobbled up large, well-established multispecialty clinics that were the dominant groups in smaller markets--places like Vero Beach, Fla., and Jonesboro, Ark. This maximized the company's influence with the giant insurance companies. The PhyCor approach acknowledged two fundamental realities about the business of medicine: that the patient-doctor relationship remains personal; and that the market for medical care is, by its nature, local. For that reason, being able to claim a major share of physicians in a given community--not signing up lots of doctors nationwide--is what counts in gaining management efficiencies and leverage with HMOs. But House didn't really accept that. From early on he envisioned someday marketing MedPartners as a national medical "brand," whose doctors would be sought out by patients across the country wherever they moved or traveled, just as they found comfort pulling in to a Midas Muffler shop or Ramada Inn. This concept--if it could work at all--required getting not just big, but enormous. House told securities analysts he was aiming at 50 major markets across the country. He figured it would take him another five years to accumulate the heft he needed. He told analysts he was building a $20 billion company. House, of course, couldn't have attempted such an extraordinary roll-up without having stock to use as currency. Smitten with PPMs, drawn by the Scrushy connection, obsessed with growth, Wall Street had urged MedPartners on. "Every analyst and every fund manager was saying, 'Go, guys, go!'" recalls Scrushy. MedPartners shares had gone public in early 1995 at $13; they topped $22 after a month and hit $36 less than a year later. House's 6% of the company (including options) was suddenly worth $72 million; Scrushy's personal stake was worth $29 million. As competition among PPMs heated up, it triggered a gold rush for physicians' practices. Purchase prices sometimes reached $500,000 or more per practicing doctor, producing a seven-figure jackpot for the senior physicians who actually owned the business. House stoked his company's growth with huge deals at eye-popping prices. He paid $413 million for a large, marginally profitable California group called Mullikin. (PhyCor had offered up to $260 million.) Even before that purchase closed, House announced another: $343 million for a struggling California PPM. Six months later he bought Caremark International, based in Chicago, for $2.5 billion. And there were hundreds of smaller acquisitions. "Larry loved to do deals," recalls J. Brooke Johnston Jr., MedPartners' former general counsel. "We were doing as many as 20 at once around the country." Says Gerald Wicker, then CFO for the company's Eastern operations: "Every deal that was brought to me, I'd ask, 'Why do we want to do this deal?' The answer always was, 'Well, if we don't do it, PhyCor will.' It was almost like a madness sale. It was frantic." But for House it was a giddy time. In June 1997 he received a regional Entrepreneur of the Year award from Ernst & Young. House loaded two of his company's corporate jets (MedPartners eventually had six) with his wife, assorted subordinates, a photographer, Macallan single-malt Scotch, and Dom Perignon champagne, and flew to the black-tie awards banquet at the Ritz-Carlton in Atlanta. Before long, MedPartners had become the biggest company in Alabama--it was even bigger than Scrushy's HealthSouth. In Birmingham, House set about building the biggest French chateau in Alabama--even bigger than Scrushy's walled estate. It is a 34,000-square-foot monster with landscaping modeled after Andrew Jackson's Hermitage in Tennessee--which is to say, in the shape of a guitar. Scrushy rubbed elbows with sports stars at company marketing events; House decided to sponsor a MedPartners racecar on the Nascar circuit. Scrushy had given House a job when he was down; had lined up his new company's financing; and was the main reason MedPartners had credibility on Wall Street. Was House grateful? In a long local newspaper feature honoring House as Birmingham Businessman of the Year, House hadn't even mentioned Scrushy--an oversight the HealthSouth chief grumbled about for weeks. For one stretch of several months, says Scrushy, House wouldn't even return his phone calls. Even that might have been forgivable if MedPartners was giving lots of rehab referrals to HealthSouth, something Scrushy had always assumed would be part of the plan. But House wouldn't even let HealthSouth bid on such business. "I don't think it was a priority for Larry," sniffed Scrushy. "That hurt," he added later. "I helped him, but he wouldn't help me." As House's buying spree continued, MedPartners shares slipped below $25. Analysts started to fret about its ability to swallow so much so fast. House responded by repricing employee stock options and dismissing the problem. "We built this company for high growth," he told a reporter. "The infrastructure is there; the management is there. We know what we're doing, and we do it extremely well." But they didn't know what they were doing, and it was painfully apparent to many inside the company. As former Caremark CEO Lance Piccolo, now vice chairman of the MedPartners board, puts it: "Larry was driving a racecar at full speed with no steering wheel." Here was one difference between Scrushy and House that really mattered: Scrushy knew how to run a far-flung health-care network, and House didn't. HealthSouth managed everything out of Birmingham: construction, purchasing, billing, even personnel. While this kind of top-down management may sound impossibly bureaucratic, Scrushy's troops made it work efficiently. Needed supplies and authorizations arrived within 30 days. Administrators who couldn't hit budget targets were fired. Says Scrushy: "We can call 'em and tell 'em, 'Jump through hoops! Stand on your head!'" But when House tried to adopt the model, it was a disaster. MedPartners assumed all hiring authority once it bought a practice; not even a records clerk could be hired without written approval from Birmingham. But at MedPartners, when an administrator made such a request to the central bureaucracy, nothing happened. For a time, no one could spend more than $500 without seven signatures on a form--including that of the company's CFO. As often as not, the request would be ignored. "You couldn't get their attention," says Dr. Stephen Hochschuler, chairman of the Texas Back Institute, then a 27-doctor MedPartners orthopedic group in the Dallas suburb of Plano. "If you called the top people direct, you were a troublemaker. If you went through their system, you didn't get an answer. Everything was held up until we put a gun to their heads." Adds the medical chief of another prominent MedPartners clinic: "Birmingham was a black hole." As the top administrator at the 120-doctor Diagnostic Clinic in the Tampa Bay area, Robert Dippong had $250,000 in spending authority before his group became part of MedPartners in 1996. The day after the purchase, he recalls, "I couldn't even buy toilet paper." Worse, Birmingham wouldn't process his requests to buy toilet paper. Under MedPartners, says Dippong, spending requisitions were constantly lost; leases took months to get signed; jobs couldn't be filled. "There were just hundreds of little things you couldn't get done," he says. Doctors at a south Florida practice summoned a regional MedPartners executive to their clinic to complain about constant delays in getting their bills paid. When he arrived for the 7:30 A.M. meeting in the doctors' boardroom, the building was dark; the clinic's power had been shut off. The determination to control everything from Birmingham often defied common sense. When MedPartners discovered that the boiler room of a newly acquired Los Angeles facility needed painting, it decided to dispatch its own crew of painters--from Birmingham--to do the job. Plainly, the notion that MedPartners would reduce administrative headaches and decrease costs--one of its main promises to the practices it was buying--didn't pan out. The other prong of the company's strategy--the idea that it would negotiate better managed-care contracts--didn't take shape either. For all its size, the company never had a large enough share in any one market to muscle better deals out of the HMOs. "That was an assumption that just didn't play out," says Bill Dexheimer, MedPartners' first chief operating officer. "You need too much critical mass to create any leverage. The payers were too powerful." In the mid-1990s, California appeared to be leading the nation toward a new approach to the problem of soaring medical costs--an approach called "global capitation." A capitation contract in effect shifted the financial risk of patient illness from the insurer to the physician. It did so by paying a practice a fixed monthly sum to provide care for each insured patient. Thus, if a patient rarely saw a doctor, the practice made a profit on that patient. But if a patient needed a lengthy hospital stay, the practice would have to pay the bills and take the hit. For physician groups like MedPartners, capitation offered potentially huge rewards and equally outsized risks. The trick was to minimize expensive procedures and hospital stays. Managing that to ensure a profit is tricky enough at the level of an individual practice; for a big PPM it would be an enormously complex task. Succeeding at capitation was so difficult--and required such finely calibrated management skills--that other PPMs ran in the opposite direction when they saw an insurance company armed with a capitation contract. Not House. One reason MedPartners had been willing to pay so much for Mullikin, the California group, was that the company had a reputation of being able to manage complex capitation risk. Shortly after buying the company, Larry House told analysts that he had acquired the capitation expertise MedPartners needed. House placed 44-year-old Mark Wagar--a 6-foot 8-inch former college basketball player and Mullikin executive--in charge of MedPartners' Western operations. MedPartners had made a half-dozen big acquisitions in California--some of which were major turnaround projects. Each group had its own computer systems, claim centers, and referral policies and separate contracts with insurance companies, hospitals, and other outside providers. House's buying spree had left the company with 140 different clinic locations--some in the same building. All this had to be integrated at the same time as the company was trying to get a handle on capitation--for more than a million customers. And every few months House would announce a new deal, throwing another ingredient into the stew. Yet by mid-1997, House and Wagar were publicly declaring that they had pulled it off. Integration had been completed, MedPartners told market analysts; the Western division was making millions. In early July, House announced that he was moving Wagar to Birmingham to become president and COO of the entire company. Wagar and his team, said a MedPartners press release, had "exceeded all their goals related to patient service and financial results." As his once-tiny rival blew past his company, PhyCor CEO Joe Hutts was worried. "If they continued to grow and grow, they might have supplanted us as the standard," Hutts says now. "It's very important to be regarded as the leader." So Hutts decided to buy MedPartners. Hutts, a soft-spoken Baptist who prayed over his company's deals, had reason to believe that MedPartners would entertain his offer. Back in May 1995--just ten weeks after MedPartners went public--Larry House had arranged a lunch meeting with Hutts at a quiet little coffee shop in a small town halfway between Birmingham and Nashville. At that time PhyCor, with its 1,100 doctors, was three times MedPartners' size. Which is why Hutts was startled when, over meat loaf and iced tea, House asked him if PhyCor was for sale. No, replied Hutts, trying to hide his incredulity: He and his three co-founders were in it for the long haul; they felt certain their company could have a fundamental impact on the nation's entire health-care system. "Well," House told Hutts, "if you ever want to do a deal, I'm either a buyer or a seller." Now, in the fall of 1997, it took just two meetings to agree on an acquisition. Hutts insisted on being the acquirer and on keeping his team and board intact. House had no objections. The CEOs agreed on a pooling transaction amounting to about $36 per MedPartners share; at the time, the stock was trading at less than $27. Only two MedPartners directors would get seats on the new company's board--House and Scrushy. On Oct. 29, 1997, the two companies unveiled their "definitive agreement" to merge. The deal would produce an $8.4 billion business, associated with doctors in 44 states. Hutts called the merger "potentially the most important combination in the history of health care." But instead of cheering the deal, Wall Street gave it two thumbs down. It reasoned that the two companies were just too different to make the merger work. The stocks of both companies began to sink. Nine weeks later, the deal was abandoned. In announcing that the merger was being called off, Hutts cited the two companies' divergent styles. What he didn't say was that PhyCor's due-diligence team, troubled by what they were finding, had dug deeper even after the deal had been publicly announced. Says PhyCor CFO John Crawford: "Some things didn't make sense." And the more they dug, the worse MedPartners looked. The California integration was a joke. The information-management systems were in chaos. The reserve set up to cover incoming bills from outside medical providers was inadequate. Thousands of unpaid claims were piled up. At the same time, merger and restructuring reserves had been drained to hit earnings numbers. Says PhyCor COO Tom Dent: "California was frightening." The PhyCor executives couldn't see how MedPartners could deliver on its projections for future earnings. "It was obvious," says a PhyCor director, "that MedPartners' senior management didn't know how broken the company was." For House, PhyCor's decision was a double whammy. First, it meant that he would lose a big-time golden parachute. As FORTUNE has learned, House had initially negotiated a ten-year exit package valued at a staggering $84.2 million. Among its more unusual features: House would be given MedPartners' largest corporate jet (valued at $30 million); the company would pay its operating expenses ($3.8 million a year); and he would receive seats in a luxury box for Chicago Bulls games (total value: $309,000). Belatedly embarrassed at having signed off on the deal, PhyCor executives, by bringing the matter before both boards, had managed to renegotiate it down--to about $56 million. Equally bad for House, he would now have to deal with the problems that had been building up for years. House's solution? Blame subordinates. Wagar, he complained, had "duped" him. (Wagar insists he concealed nothing from House but declines to comment further.) House told the board he had known nothing about the California troubles until late November, when a monthly report from the Western operation had shown a huge, unexpected loss. But the board wasn't buying it. "It's inexcusable to say he didn't know," says vice chairman Piccolo. "He was paid a hell of a lot to know.... You can't run a business just by buying. You've got to manage it." By early January, Piccolo had secretly rounded up six votes from the 11-member board to oust the CEO. On Jan. 5, 1998, House told his directors that Wagar had to go. But Piccolo suddenly announced that he was making a motion to fire House--and already had the votes he needed. After a stormy half-hour, House summarily adjourned the meeting. Chaos reigned for the next two days until Scrushy brokered a deal. Wagar would keep his job; Scrushy would privately persuade House to resign. So on Jan. 7, after announcing the termination of the PhyCor merger, MedPartners began airing its dirty linen: It would take a $115 million restructuring charge in California and thought future earnings would fall well short of expectations. The next day, MedPartners shares plunged 45%. Eight days later House was gone. As part of his "retirement agreement," he received a lump-sum payment of $6 million and a two-year consulting agreement worth another $1.7 million annually. With House's departure, MedPartners announced the appointment of its new board chairman and acting CEO: Richard Scrushy. There was grace in Scrushyland--at least initially and in public. On easing out his old friend, Scrushy announced that House was going to work for a venture capital firm Scrushy had established. But House soon left to start a firm of his own called VentureHouse, which he operated out of his guitar-themed home, and did not stand for reelection to the HealthSouth board. Scrushy took huge charges to try to get the bad news out all at once and even bought a million MedPartners shares, publicly declaring the stock "seriously underpriced." But after less than three months he left the job, bringing in a turnaround expert named Mac Crawford. Scrushy now tells FORTUNE that he had no idea how ugly things really were. It turned out that MedPartners was losing $200 million a year in California. "It was like the damn forest was on fire out there," says Scrushy. The charges and operating losses just kept growing. MedPartners closed 1997 with a net loss of $821 million. Lawsuits from shareholders and physicians began to pile up. Crawford has announced his intent to sell MedPartners' entire PPM operation by the end of 1999, focusing instead on its profitable $2 billion prescription-benefit-management division, acquired in the Caremark deal and previously a corporate afterthought. As Crawford hatched his turnaround strategy, MedPartners shares bottomed out below $2. They ended 1998 down 76.5%; the stock is now trading at around $5. (The board has given big options packages to Scrushy and Crawford at $3.25 a share.) Crawford now believes the PPM industry was misguided. "Intuitively, the concept of aggregating physicians makes sense," he says. But "I don't think there's a company out there that can manage a doctor's practice that much more efficiently." Wall Street seems to agree. The collapse of the MedPartners-PhyCor deal sent PPM stocks tumbling, and after being burned too often by health-care stocks (remember Columbia-HCA and Oxford), the market, more than a year later, remains sour on the entire industry. Scrushy is still on the MedPartners board and tells FORTUNE he has no intention of interfering with an extraordinary move by Crawford to cut off millions in exit payments that House and at least four of his former top executives claim they are due under their company contracts. A Crawford confidant explained the motivation succinctly: "He would be goddamned if he would pay Larry House another nickel." And so, American capitalism has again managed to brutally separate true entrepreneurial royalty from mere poseurs--and in the process, thousands of investors from their dollars. Larry House has been left alone, in his manse, to count his millions. And in Birmingham, there are no more pretenders--at least for the moment--to King Richard's throne. |
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