Taxpayers to pay salaries of CEOs/CIOs of Mutual Funds - The Honest Truth By Ajit Dayal

Taxpayers to pay salaries of CEOs/CIOs of Mutual Funds

5 OCTOBER 2018

IL&FS, the holding company had set up and helped finance over 250 projects and took total debts of over Rs. 91,000 crore. Many of these borrowings were short-term in nature, much of it from liquid funds, and were used to fund long term projects

Now, IL&FS is in trouble and has already defaulted on some debts. The credit rating agencies have failed, yet again, to flag the risks. They began to blow the whistle on September 10th and converted the 'AAA" debt of ILFS to Default or lower credit ratings, after the defaults occurred. The rating agencies continue to be compromised with their ethically flawed business model. They have a license from the regulator to rate with a view to protect investors. However, they are paid by the very companies that issue the debt - why would they jeopardise their revenue streams by giving companies a lower debt rating and bear the risk of losing a client?

Make no mistake about it: the default by IL&FS entities is a moment of crisis in the Indian financial services industry.

The trigger this time was not an external Lehman bankruptcy; it was a combination of:

  1. Slower credit flows from a PSU banking system which had stopped lending as losses on past loans mounted - and yet there was a need for more credit to fund the continued growth of the Indian economy;
  2. Higher interest rates in the US which resulted in foreign investors demanding more returns for taking "risky" bets in all emerging markets, including India;
  3. Higher oil prices that had caused the import bill to surge exposing, once more, the shallowness of successive governments in the challenging task of trying to wean India away from oil imports;
  4. A weak INR that had foreign investors worried about the surge of India's balance of payments and a government refusing to understand the problem, and, finally
  5. The default by IL&FS which has made everyone realise how the mutual funds have made us all hostage to their AuM-gathering business models with no regard for investor - or product - safety.

Borrow short, invest long.

For decades, we have had governments correctly focusing on building out India's need for better infrastructure - be it power plants, ports, airports, or roads. For decades every government from the Vajpayee-led BJP to the scam-tainted Manmohan Singh-led UPA governments to this government has failed to create a viable market for funding projects that take 5 to 10 years to build out and have a potential earning lifespan of 20 to 30 years. The easy solution for all governments was to make phone calls to the PSU banks, to UTI (before that went bust), and to LIC to fund these pet, but necessary, projects.

Every government has, through poor policy implementation, incrementally contributed to the crisis we face today; the recognition that many of these projects are not economically viable and have been badly funded. The fact that many politically well-connected founders have stolen money via the traditional practice of over-invoicing and profiteering before even the foundation stone for a project is laid has not helped in the long-term 'viability' of the projects. Short-term money has been used to fund long term projects. Short-term money has been used to prop up the cosmetic face of a healthy economy to showcase our world-beating rates of growth in GDP.

Every bad plot needs a villain and, in this case, the mutual fund industry has been eagerly volunteering to play the role with great gusto - for a price, of course. While there is no free lunch in economics, the actors in the financial services industry ensures that there is no free air, water, breakfast, dinner, coffee, tea, or dessert. Not only have they made it their birthright to extract money from you, they sell you food with spice levels that cause you indigestion. Here is what Uday Kotak has to say (Outlook Business, February 16th, 2013) about the 2007-2008 period when the Reliance Power IPO knocked out investors: "From an investment banking perspective you need to offer what investors want at all times, but as a lender you need to decide if it makes sense for you. For example, in 2007-08, there was exuberance around the Indian infrastructure story - the media believed it, the policy makers believed it, investors wanted it, so we brought some of these companies to market. It was probably high risk but we got them in. Offering equities is like leaving to the consumer the choice of how much spice they want in their food - if they want a high risk bet with the upside and the downside of equities, the choice is really theirs - and as a cook I need to give them that. But as a banker, I need to decide how much spice is good for me; I did not like spice in my food during that time so we did not take exposure to infrastructure."

Chew over that for a while - and next time be careful of what you eat.

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Mutual funds rescued by RBI in 2008 - and they got to keep their illicit salaries and bonuses

Prior to the Lehman bankruptcy of September 2008, the mutual funds in India went on a spree of mis-selling and mis-labelling their products. Their "guaranteed" monthly income products made investments in shady companies doing shady stuff in the shady real estate sector. They launched mutual funds that would give you a breathtaking piece of the action of TIGER India or Resurgent India - or whatever India you wanted to believe in. Your level of spice, their cooking skills...

Eventually, all this came to a head when Lehman went bankrupt in USA on September 15, 2008. Money flows from the developed world to India dried up and Indian companies and Indian households, who had parked their extra cash with mutual funds, wanted their money back either to keep it safely in an FD or use it to spend. The companies which had borrowed - via the mutual funds - were unable to service their debt or repay their debt. They were all running one giant Ponzi scheme: using new short-term debt to repay old debt and interest. Friends contacted me in shock: the money they had invested in debt mutual funds with "guaranteed" incomes lost 30% to 40% of their NAV. How was this possible? This was money kept aside for their children's education!

After having collected thousands of crore of your money, earned fees on it, and then invested it irresponsibly what did the mutual fund industry do when the crisis hit? They went with hands folded to the then SEBI Chairman, C. B. Bhave, pleading with him to impose rules that would limit the level of redemptions in debt mutual funds. The mutual funds earned huge fees and now wanted to stop you from taking back your money.

Bhave refused. His logic: you earned the money, salaries and bonuses on the way in, now suffer on the way out!

The mutual fund industry went over Bhave's head to the Ministry of Finance. The usual suspects and doyens of corporate governance, who should be stripped of this false flag they carry, got the RBI to bail them out with a line of credit. This is what the then Deputy Governor of the RBI, Usha Thorat, had to say at a conference in Seoul, South Korea on June 29, 2009 (the words underlined by me to show the role of mutual funds): The immediate result of tightening of the money and credit markets in October 2008 created demands on banks that were already expanding credit well beyond the resources raised from the public by way of deposits. Companies which were substituting overseas credit and capital market sources with bank funds started withdrawing funds parked with mutual funds and utilising their undrawn limits with banks. Some of the companies that had issued commercial paper in the market - especially the real estate companies and the non-banking companies - found it difficult to roll over the maturing paper. The Commercial Paper and Certificates of Deposit markets became illiquid and mutual funds started facing severe redemption pressures. Hence, in the interest of maintaining financial stability, the RBI instituted a 14-day special repo facility for a notified amount of about $ 4 billion to alleviate liquidity stress faced by mutual funds, and banks were allowed temporary use of Statutory Liquidity Ratio (SLR) securities for collateral purposes for an additional 0.5 per cent of Net Demand and Time Liabilities exclusively for this.

Bhave never got his extension to be the SEBI Chairman for another two years - an unusual step.

But the mutual fund industry got a lifeline: and they got to keep all the salaries and bonuses they had earned from mis-selling the products to you in the 2005 - 2007 mania. When things get tough, the tough can make that phone call to the government and have the tax payer bail them out. And those who stand in the way, like Bhave, get going. Kaun Banega Crorepati has a star cast loaded with mutual fund employees.

Fast forward to 2015-2017: Not much has changed. Just add '10' to the 2005-2007 time pattern of misbehaviour of the mutual fund industry. The characters are the same; the brand names are the same: saints may die but villains are eternal.

Mutually yours: I become rich and you bail me out.

Over the past few years the mutual fund industry has been riding a boom. After the boom years of 2005-2007, came the redemptions from 2008 till 2010 and the hatred of mutual funds. However, with the inability of real estate to give any sensible rates of returns (in fact, many investments in real estate have ended in losses), with gold hardly giving any returns, and with rates on Fixed Deposits heading south, the Modi India story was like a ray of badly needed sunshine in a gloomy investment landscape.

The mutual fund industry was ready to give investors whatever level of spice they wanted. And more. If SEBI wanted to control how much money was paid as commissions to prevent mis-selling, the fund houses racketeered their way into growth of assets by a flurry of launches of closed-end funds. In 2017, according to PersonalFN, "fund houses launched as many as 36 close-ended funds garnering an asset size of nearly Rs 11,000 crore. In comparison, only 13 open-ended schemes were launched, picking up about Rs 6,000 crore." This was to beat the SEBI rule of capping commissions on open end funds. The closed end funds probably gave the middle-men up to Rs 500 crore in commissions to gather those assets - without any disclosure to the investor that such high fees were paid.

Balanced funds were another wrongly sold product. Designed as equity funds with an allocation of over 65% to equity to avail of tax breaks, over Rs. 50,000 crore in AuM was ratcheted up - and fees for the agents that got you in. Today, investors are witnessing declining NAVs. These funds remain unbalanced and have not prevented the loss of capital - with such a high equity allocation, they cannot!

The Hindu Business Line reported on August 23rd, 2018 that - while addressing the annual meeting of the industry body, AMFI - SEBI Chairman indicated "that SEBI is also planning to roll out new regulations for close-ended schemes soon, he said. As a word of caution to debt mutual fund managers, Tyagi said most of the funds are invested in low-rated, high-risk papers to generate maximum returns. There is nothing wrong in it, but they need to be vigilant and appropriately value their investments even though a bulk of the money comes from well-informed institutional investors, he said."

The Hindu Business Line also reported that "SEBI Chairman Ajay Tyagi has raised concern over concentration of assets in mutual fund industry among the top fund houses and the need for more competition to bring down the cost for investors. Speaking at the annual Association of Mutual Fund Industries in India summit on Thursday, Tyagi said the top four mutual funds account for 50 per cent of the industry's asset under management and the top seven fund houses control 70 per cent of the industry assets. The top seven fund houses generate 60 per cent of the mutual fund industry's revenue and 40-50 per cent of the industry's profit before tax."

The large fund houses, I submit, don't have the best track records of performance. They probably have the best distribution armies working for them - and not always in the interest of the investors. As the SEBI Chairman has noted, the costs for investors are still too high. The reach of many fund houses is deep within the system of policy-making and politicians. Their brand image numbs investors into a state of dumb acceptance and, like a fraudulent godman, they pounce on their unsuspecting victims and feed them the promised prasad which ends up causing severe indigestion.

No matter how illiquid the underlying stories of small caps and mid cap stocks were, most mutual fund houses took in more money - even when deploying that money was a challenge. Some of the larger funds by HDFC Mutual Fund would take over 200 days to sell their Top Holdings to honour your request for redemptions! (Small and mid-cap funds: A trap for investors?). Sadly, many investors have been saddled with excessive equity allocations in their portfolio and are suffering from that today.

Table 1: Don't keep it simple, keep it large. AuM of HDFC AMC and Kotak AMC show contrasts and similaritie (in Rs crore)

Scheme Category HDFC AMC Kotak AMC
Sum of Corpus (Cr.) % of Assets Sum of Corpus (Cr.) % of Assets
Commodity Funds 631.74 0.20% 522.25 0.38%
ETFs-Gold 428.04 0.14% 359.51 0.26%
FoFs-Gold 203.70 0.06% 162.74 0.12%
Debt Funds 144,583.45 46.06% 79,905.79 58.01%
Banking and PSU Fund 2,922.01 0.93% 980.53 0.71%
Corporate Bond 11,763.06 3.75% 938.47 0.68%
Credit Risk Fund 18,243.33 5.81% 5,366.70 3.90%
Dynamic Bond 1,100.83 0.35% 609.69 0.44%
Fixed Maturity Plans 21,447.87 6.83% 10,759.56 7.81%
Floating Rate 12,252.34 3.90% -- 0.00%
Gilt-Short & Mid Term 1,472.11 0.47% 430.00 0.31%
Liquid 49,303.39 15.71% 27,269.21 19.80%
Low Duration 10,232.27 3.26% 5,453.14 3.96%
Medium Duration 1,425.65 0.45% 4,622.50 3.36%
Medium to Long Duration 909.73 0.29% 1,795.84 1.30%
Money Market 3,923.65 1.25% 5,615.34 4.08%
Overnight Fund 146.07 0.05% -- 0.00%
Short Duration 9,441.15 3.01% 8,079.15 5.87%
Ultra Short Duration -- 0.00% 7,985.67 5.80%
Equity Funds 87,428.42 27.85% 38,678.71 28.08%
Equity Linked Savings Scheme 8,863.95 2.82% 807.74 0.59%
ETFs-Banking -- 0.00% 5,224.95 3.79%
ETFs-Index 255.09 0.08% 591.97 0.43%
Focused Fund 503.59 0.16% -- 0.00%
Index - Nifty 418.18 0.13% -- 0.00%
Index - Sensex 259.03 0.08% -- 0.00%
Large & Mid Cap Fund 1,332.83 0.42% 2,568.53 1.86%
Large Cap Fund 17,835.75 5.68% 1,449.07 1.05%
Mid Cap Fund 21,952.01 6.99% 3,453.40 2.51%
Multi Cap Fund 22,797.82 7.26% 22,741.48 16.51%
Sector Funds-Infrastructure 4,271.41 1.36% 452.46 0.33%
Small Cap Fund 5,110.86 1.63% 823.77 0.60%
Value / Contra Fund 3,827.90 1.22% 565.34 0.41%
Hybrid Funds 77,977.24 24.84% 18,553.55 13.47%
Aggressive Hybrid Fund 23,136.61 7.37% 1,921.14 1.39%
Arbitrage Fund 3,814.16 1.22% 11,468.04 8.33%
Balanced Advantage 39,215.18 12.49% -- 0.00%
Balanced Hybrid Fund 732.27 0.23% -- 0.00%
Capital Protection Funds -- 0.00% 453.34 0.33%
Conservative Hybrid Fund 3,404.86 1.08% 320.26 0.23%
Dynamic Asset Allocation -- 0.00% 2,053.31 1.49%
Equity Savings 7,512.86 2.39% 2,337.45 1.70%
Multi Asset Allocation 161.30 0.05% -- 0.00%
Other Funds 3,251.31 1.04% 77.35 0.06%
FoFs (Domestic) 22.15 0.01% 36.43 0.03%
FoFs (Overseas) -- 0.00% 40.92 0.03%
Solution Oriented - Children’s Fund 2,438.77 0.78% -- 0.00%
Solution Oriented - Retirement Fund 790.38 0.25% -- 0.00%
Grand Total 313,872.15 100.00% 137,737.65 100.00%

Data as on August 31, 2018
Source: PersonalFN, ACEMF

The reaction of equity investors to any extended market downturn is likely to be: step back from mutual funds. The one huge, unquestionable success of the Modi government was a return of confidence into stocks: a sense of optimism. The mutual fund industry has gamed the Prime Minister. They have abused his goodwill with the people and sacrificed his tireless confidence-generating speeches with their shady asset gathering practices.

The mutual fund industry has, once again, put India's financial system on the brink of disaster by mis-allocations from the liquid funds. An article by PersonalFn on September 28, 2018 noted "the allocation of the total corpus of Rs. 5,70,577 crore together held by 41 liquid funds, as of August 31, 2018. Surprisingly, of this, about Rs. 3,93,088 crore worth of assets are in commercial papers and about Rs. 10,854 crore in Corporate Debt instruments. That's about 70.8% of the total assets in liquid funds. Notably only about 10% of the commercial papers held by liquid funds belong to Public Sector Banks, while 54% belong to NBFCs, which isn't safe either. The remaining 36% of the commercial papers held by liquid funds belong to corporate entities operating in other sectors. Liquid fund managers are clearly risking investor's money by betting on instruments issued by corporates, for higher yield."

Table 2: Should liquid funds still bet on corporates?

Instrument Type Corpus (Rs. in Cr.) % of Total Liquid Fund Corpus
Commercial Paper 393,088 68.89
Certificate of Deposit 64,566 11.32
Treasury Bills 57,125 10.01
Deposits 22,182 3.89
Cash & Cash Equivalents and Net Assets 16,703 2.93
Corporate Debt 10,854 1.90
Bills Rediscounting 2,537 0.44
Cash Management Bill 1,784 0.31
Deposits (Placed as Margin) 1,121 0.20
Government Securities 460 0.08
PTC & Securitized Debt 156 0.03
Total Liquid Fund Corpus (Rs. in Cr.) 570,577 100

Data as on August 31, 2018>
(Source: ACEMF)

A liquid fund is supposed to be liquid and pass the simple test: give me my money when I need it. But, in a rush to gather assets, many fund houses converted their "liquid" funds into "credit" funds. A liquid fund should invest in a security that you know you can liquidate at close to the market price at any time with minimal headache and cost. Think government bonds, think debt instruments issued by PSUs like ONGC or SBI. They are safe. They are 'sovereign' risk or 'quasi-sovereign' risk. But our army of mutual fund CEOs and CIOs went on a hunt for yield. With swashbuckling skills that would make The 3 Musketeers blush, the liquid funds began to invest in private companies. So, of the Rs. 5.7 lakh crore of liquid fund investments, over 1/3rd (over Rs. 1.7 lakh crore) is in NBFCs like IL&FS. Additionally, there is more exposure to NBFCs in the other various kinds of debt funds that have been launched.

Now, if you are a corporate like Hindustan Lever, for example, you have spare cash. You keep some cash in bank deposits and some in FDs. And the rest you invest "in the market" via liquid funds or debt funds. So, when you read that liquid funds have invested in potentially risky instruments and, therefore, may not be liquid, you begin to worry. And you ask for your money back. You redeem. And so do others. The mutual fund manager knows that, if everyone redeems, there is no way he can liquidate the underlying 'illiquid' paper in his liquid fund to pay back all the investors. So he runs to SEBI, to his best friends in the Ministry of Finance, and to RBI to do what was done in October 2008: give him a bail out.

Because, the argument goes, if you don't bail me - the system will fail.

So, to use the words of The Financial Crisis Inquiry Commission (set up in the USA to study the Global Financial Crisis of 2008) "how did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives - either risk the total collapse of our financial system and economy or inject trillions of taxpayer dollars into the financial system and an array of companies, as millions of Americans still lost their jobs, their savings, and their homes?"

So how is it that the mutual fund industry - which extracts and profiteers at will - now lines up at the door asking for a bail-out?

Table 3: What is the underlying exposure of these liquid funds?

Asset Type HDFC Liquid Fund (%) Kotak Liquid Fund (%)
Certificate of Deposit 6.15 10.26
Commercial Paper 58.61 71.29
Corporate Debt 6.95 3.94
Deposits 0.46 --
Treasury Bills 23.65 7.90
Cash & Cash Equivalents and Net Assets 4.18 6.61
Grand Total 100.00 100.00
Liquid AuM, Rs. Crore 49,303 27,269
Total AuM, Rs. Crore 313,872 137,738
Liquid Aum / Total AuM 15.7% 19.8%

Portfolio data as on August 31, 2018
(Source: ACEMF)

The challenging task of rescuing IL&FS

And, when Uday Kotak is asked to lead a rescue - brilliant as he is - with what confidence do we know that the rescue IL&FS will not favour the financial services industry with a rescue package? Many fund houses, including Kotak funds, have loans to NBFCs. The Kotak funds have exposure to IL&FS.

There is a lesson to be learnt from the Lehman bankruptcy. In the US, the then Treasury of the Secretary, Hank Paulson had over USD 450 million worth of shares in Goldman, Sachs. Hank Paulson was the Chairman & CEO of Goldman, Sachs before he took over as the effective Finance Minister in the US government. After allowing Lehman Brothers, the arch-rival of Goldman, to collapse on the weekend of September 14 and forcing Lehman to file for bankruptcy on September 15, 2008, the US government devised a rescue plan of USD 85 billion for insurer AIG so that it would not go under. AIG's first use of the USD 85 billion government money it received in September 16, 2008 was to pay Goldman, Sachs the USD 13 billion that AIG owed to Goldman. (Goldman's share of AIG bailout money draws fire)

If AIG had not paid Goldman the USD 13 billion which AIG had lost on a derivatives bet to Goldman, would Goldman have gone bankrupt? If Paulson's Treasury had not rescued AIG, would his USD 450 million of shares in Goldman been worth a lot less - maybe zero?

Ironically, Kotak and Goldman were partners in India. Ironically, they are/were being asked to design rescue packages. The difference is that Paulson had left his job at Goldman for a job at the government. Kotak is still, as a quote in LiveMint noted, "an active" banker and he is heading a rescue committee; a temporary job, as such. To quote the October 4th article in LiveMint which focused on the eligibility of former SEBI Chairman Bajpai's appointment to the Board of IL&FS, "While some questions were also raised about the choice of an active banker for the new board, in the absence of specific information about the Kotak Mahindra Bank's lending to IL&FS, there does not seem to be any real conflict of interest".

Still, as the head of the SEBI Committee of good governance and being the professional that he is, Kotak should reveal the books and exposure of companies that he controls - from Kotak bank to Kotak mutual funds - as of August 31, 2018 to ensure that the challenging task at hand can be addressed head on and he can move ahead with an execution plan with sincere professionalism. And the task is huge: to ensure that redemptions from the (mis-sold) mutual funds do not freeze money flows to keep the economy humming.

Table 4: Summary of credit exposure (loans and non-funded, like guarantees) of some banks to commercial real estate (developers) and NBFCs.

Name of Bank Exposure to sector (%)
Commercial Real estate NBFCs
Kotak Mahindra Bank 3.79 4.57
HDFC Bank 2.95 4.76
Axis Bank 2.08 1.50
Yes Bank 5.90 2.50
IndusInd Bank 2.02 2.39
ICICI Bank 3.49 5.67
SBI 1.29 11.74

Source: Basel III Disclosure reports of Banks.
As at 31st March, 2018.

Meanwhile, while the mutual fund houses will jockey for positioning themselves to get heaps of the tax payer money that will come in from any bail out, you should sleep well knowing that your money is working hard to reward the gunslingers who masquerade as mutual fund managers. They have their salary, their bonus, and their ESOPs. You have your declining NAVs. If you like that cosy relationship where your money subsidises the lifestyle of those who compromise your trust and your investments, continue to be enamoured with many of the mutual fund houses.

The collapse of Lehman and the Financial Holocaust is barely 10 years in the past - and, like goldfish, the gullible wait for the guillotine to crush their savings.

Many investors continue to be misled, to be lied to, and to be ripped off.

But they remain loyal to 'the brand'.

Or people tend to have blind faith in 'aapro' good Gujarati/Marwari/Punjabi/Sindhi who runs or owns the fund house or financial conglomerate.

For those 'bhakts' who prefer caste to literacy, my very best wishes.

For the rest of us who prefer living in a world of meritocracy and professionalism, I hope you will relook at your mutual fund allocations. Or be prepared to start paying a 2% SOMFCEOCIO cess on your income tax - a tax to ensure there is always money for the Salaries Of Mutual Fund CEOs and CIOs. Jai Hind!

PS: 15 September 2018. The world remembered the biggest financial bankruptcy in history: Lehman Brothers. But you did not hear the entire story. That's because the full story - it was a Financial Holocaust - was hidden from you...but no longer. For the full story about what happened that fateful day 10 years ago, and since, read Ajit Dayal's exclusive report - A Financial Holocaust Eliminated from History.

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)

Quantum Long Term Equity Fund and Quantum Equity Fund of Funds Quantum Gold Fund
Quantum Liquid Fund
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An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% in total in both; Maybe 20% in QLTEF and 60% in QEFOF 20% Keep aside money to meet your expenses for 6 months to 2 years
Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"
Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is Founder of Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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2 Responses to "Taxpayers to pay salaries of CEOs/CIOs of Mutual Funds"


Oct 7, 2018

Excellent article with so many points to ponder. The robber barons seem to be more in the financial industry than anywhere else.


Nidige Kumar

Oct 6, 2018

Nice Read. Keeping away from these majority 'MF villains' is really a challenging task. These liquid funds must be renamed as 'Gas Funds'. Gas escapes easily without any traces left.

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