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Tokenization: The Legal Take on Jobs Act Equity Crowdfunding and Security Token Offerings

Podcast: Regulation A+ Crowdfunding

Tokenization podcast MSR

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If you’re a entrepreneur, you’re probably looking for some way to raise capital. You probably have heard of crowdfunding, but you may not have heard of the Jobs Act of 2012 and how it relates to crowdfunding – which is significant because its potential is enormous. Besides Regulation A+, Reg. CF, and Title II crowdfunding options to name a few, now investors and issuers can take advantage of the “tokenization” of assets via Security Token Offerings based on blockchain technology. However, there are complicated rules associated with all aspects of crowdfunding, which is why it’s so important to have legal representation throughout all phases of the process.

In this podcast episode, we interviewed crowdfunding attorney Mark Roderick from Flaster Greenberg PC who gave us many insights on crowdfunding in general, plus his take on tokenization and what security tokens can actually do for issuers and investors alike. Forget what everyone says about raising money. As stated on the podcast, crowdfunding is a marketing business, but it’s smart to have legal counsel at all times too – which is why anyone thinking of getting involved with crowdfunding on any level would be wise to contact Mr. Roderick and read his crowdfunding blog where you can find hundreds of posts with excellent information dedicated to legal crowdfunding success. See that? Sometimes lawyers can be your friend!

And speaking of crowdfunding, according to Mark, about 90% of the Reg.A+ crowdfunding deals he’s seen is regarding real estate. You know what most of the Reg.CF deals are? (here’s a hint).

Questions? Let me know.

Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

Mark Roderick Explains Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

You want to reward and incentivize your CFO and CMO with equity in the company. What’s the best approach?

First, make sure equity provides the right incentives. For the CFO almost certainly, because the CFO shares responsibility for the profitability of the whole company. For the CMO, maybe not. If we want the CMO focused on sales, maybe a cash commission makes more sense. On the other hand, you might decide that owning stock will have a positive psychological effect for your CMO, even if it doesn’t offer a direct incentive.

With that box checked, these are the most common equity-flavored alternatives:

  • Restricted Stock: The CFO might receive a total of 100 shares of stock today, with her right to receive distributions and otherwise enjoy the full benefits of the stock subject to a vesting schedule. The vesting schedule might be based on time (g., 20 shares per year for five years), economic milestones (e.g., 20 shares for each year showing a growth of at least 20% in cash flow or EBITDA), or a combination of the two.
  • Stock Options: The CFO might be granted the option to purchase 100 shares of stock for $0.10 per share (hoping they will someday be worth a lot more), subject to the same vesting schedule. Under section 409A of the tax code, that $0.10 per share exercise price must be the true fair market value at the date of grant, not an artificially low number.
  • Incentive Stock Options: If the company is a corporation (not an LLC) and satisfies lots of special rules, the CFO might be granted a special kind of stock option, with special tax benefits.
  • Phantom Stock: Rather than actual stock, the CFO might receive a contract right intended to achieve the same economic result.

In the world of entrepreneurs generally and the Fintech and Crowdfunding worlds specifically, restricted stock and stock options are the most common choices, so I’m going to focus on those today.

Economically, restricted stock and stock options are almost identical. But the tax consequences can be quite different. For purposes of the discussion below, I’m assuming (i) the CFO’s 100 shares are worth $0.10 per share today and increase in value at the rate of $1.00 per share per year, (ii) the CFO is given 10 years in which to exercise the options, and (iii) the company is sold in 10 years.

Scenario #1: Direct Stock Issuance – General Rule

If the CFO receives 100 shares today, vesting over five years, then she has zero taxable income today because no shares have vested. At the end of the first year she has $22 of taxable income (20 shares vested @$1.10 value per share), at the end of the second year he has $42 of taxable income (20 additional shares vested @$2.10 value per share), and so on. The employee must pay tax on this income each year, while the company can claim a corresponding tax deduction. Thus, over the duration of the vesting period the CFO pays tax on $310 of taxable income and the company obtains a $310 tax deduction.

In this example the CFO will pay roughly $100 of tax on his $310 of taxable income (depending on tax bracket, state of residence, etc.). The exact amount of the tax isn’t important. What’s important is that (i) she will have to fund this cost from her own pocket, and (ii) if the company is very valuable or she owns a lot of stock, her out-of-pocket tax cost could be prohibitively high.

When the company is sold after 10 years, the CFO will receive $1,010 for her shares and have $700 of gain. This $700 would be taxed at long term capital gain rates, and at that point she’ll have the cash to pay her tax.

Scenario #2:  Direct Stock Issuance Followed by §83(b) Election

Where an employee receives stock subject to a vesting schedule, §83(b) of the tax code permits an employee to elect to report as taxable income the entire current value of the stock. Having made the election, the employee does not report any additional taxable income as the stock vests.

In our example, the CFO could make an election and report $10 of taxable income on the date of grant (100 shares of the @ $0.10 per share). She would then have no additional taxable income as the stock vests, and the company would have no tax deductions. Upon the sale of her stock the employee would have $1,000 of income, taxed at long term capital gain rates.

An election under §83(b) must be filed with the Internal Revenue Service within 30 days after the CFO receives the stock.

NOTE:  Suppose the company fails after two years. Now the CFO has paid tax on $10 and has nothing to show for it except a $10 capital loss. That’s the downside of section 83(b).

Scenario #3: Options

The CFO recognizes no current taxable income as a result of receiving options. Instead, she recognizes taxable income as the options are exercised, equal to the difference between the exercise price of $0.10 per share and the value of the stock at the time.

In the simplest scenario, where the CFO exercises options to purchase 20 shares each year, the tax effect would be almost identical to Scenario #1 above. The CFRO would recognize $20 of taxable income in the first year, $40 the next year, and so forth, for a total of $300 of taxable income. No §83(b) election is available with options.

A more likely scenario is that the CFO wouldn’t (or wouldn’t be allowed to) exercise the options each year, but rather waits to exercise until the company is sold. In this case she would recognize no taxable income until sale, and at that point would recognize $1,000 of taxable income, taxed at ordinary income rates rather than capital gain rates. The company would be entitled to a corresponding deduction of $1,000. Again, the CFO would have plenty of money to pay the tax.

Conclusion

Options are simpler than restricted stock, especially if they can’t be exercised until an exit. And the holder of an option, unlike the holder of actual stock, has no right to see confidential information that the company would prefer to keep private.

For that reason, options typically make more sense from the company’s viewpoint, even though the employee might end up paying more tax (ordinary income vs. capital gains) overall. But every company and every situation is different.

Questions? Let me know.

Podcast: Crowdfunding From a Legal Perspective

Podcast for MSR

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What does the crowdfunding sector look like from a legal perspective? How do recent and previous laws passed by Congress impact startup entrepreneurs and crowdfunding campaigns? Here to give his unique take on the subject is one of the leading crowdfunding and financial technology lawyers in the United States, Mark Roderick. In his conversation with Roy, Mark opens up about the JOBS Act of 2012, the pros and cons of equity crowdfunding, various liability concerns that startup entrepreneurs should keep on their radar and much more. You don’t want to miss a minute of this engaging episode featuring Mark!

Questions? Let Mark know.

Why Qualified Opportunity Zone Funds Are the Hottest Topic of Crowdfunding Real Estate

Podcast: MAPABLE USA 

Why Qualified Opportunity Zone Funds Are the Hottest Topic of Crowdfunding Real Estate

Mapable USA Podcast

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The word is out about Qualified Opportunity Zones (QOZ) and just about every real estate professional in the country is interested about how this IRS sanctioned program works. Investing in a QOZ Fund provides all Americans with a way to save money on their taxes and provides real estate developers with a great angle to raise money for their projects. But are these investment vehicles securities? Can non-accredited investors participate in this form of crowdfunding? How can issuers create their own fund? Listen to attorney Mark Roderick from Flaster Greenberg PC address these questions, what the intricacies of QOZ investing are, and many other items of interest on this episode of the Mapable USA crowdfunding podcast.

While most funds center around real estate projects, any form of substantial improvement into a Qualified Opportunity Zone will satisfy the requirement of a QOZ fund – and that includes bringing in businesses and employment opportunities into these distressed communities. As such, the QOZ Marketplace is a website in progress connecting and identifying Qualified Opportunity Zone tracks and census data, along with a list of Opportunity Zone Funds and real estate properties for those interested in QOZ investing. Because of their tax deferral benefits, getting people seeking to defer their capital gains taxes to invest in these funds probably won’t be an issue. But Mr. Roderick brings up a great point: because QOZ Funds are self-certified, it’s important to be on the outlook for fraud. His advice? Look for a deal with a strong foundation with reputable people – the tax deferral savings is just icing on the cake!

Recent Blog Posts related to QOZ Fund:

Questions? Let me know.

What’s an Investment Adviser in Crowdfunding?

 

investment adviser.jpgAs Crowdfunding grows and investment advisers migrate into the space, we’re going to devote a few blog posts to investment adviser basics:

  • Federal vs. State regulation of investment advisers
  • Advisers to private funds
  • Venture capital advisers
  • Duties of investment advisers
  • Registration of investment advisers

Today we start with the most basic question:  What is an investment adviser?

Here’s the definition from the Investment Adviser Act of 1940:

“[A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. . . .”

The term “securities” is very broad, covering obvious things like stock, bonds, and interests in limited liability companies, but less obviously things like (1) mortgages, and (2) blockchain tokens that are treated as securities under Howey.

EXAMPLE #1:  Molly Smith operates a Crowdfunding site that allows investors to participate in specific mortgage loans made to real estate fix-and-flippers. Because investors choose their own mortgage loans, Molly probably isn’t an investment adviser.

EXAMPLE #2:  Samantha O’Hara creates a fund that buys and sells mortgage loans made to real estate fix-and-flippers. If Samantha is deciding which loans the fund will buy and sell, she’s probably an investment adviser.

EXAMPLE #3:  John Kelly, software engineer, reads the Wall Street Journal and often gives investment tips to his friends. Because he’s not in business and not being compensated, John isn’t an investment adviser.

EXAMPLE #4:  Craig Toricelli creates a fund that buys and sells apartment buildings. Because a fee simple interest in real estate isn’t a “security,” Craig isn’t an investment adviser.

EXAMPLE #5:  Gregg Wright creates a fund that buys and sells bitcoin (buy on the dip!). Because bitcoin isn’t a “security,” Gregg isn’t an investment adviser.

A few common exceptions:

  • Lawyers, accountants, engineers, and teachers aren’t investment advisers if their performance of advisory services is solely incidental to their professions.
  • Brokers and dealers aren’t investment advisers if their performance of advisory services is solely incidental to the conduct of their business as brokers and dealers, and they do not receive any special compensation for advisory services.
  • Publishers of bona fide newspapers, newsletters, and business or financial publications of general and regular circulation aren’t investment advisers if their publications meet three requirements:
    • The publication must offer only impersonal advice, e., advice not tailored to the individual needs of a specific client, group of clients, or portfolio.
    • The publication must contain disinterested commentary and analysis rather than promotional material disseminated by someone touting particular securities.
    • The publication must be of general and regular circulation rather than issued from time to time in response to episodic market activity or events affecting the securities industry.

EXAMPLE:  Each time Cindy Liu, Esquire finishes work on an ICO, she post on her Facebook page:  “Take a look!” Even If her clients think they’re paying for the publicity as well the legal work, Cindy’s not an investment adviser, because she’s not being paid by her Facebook friends.

In that list, you don’t see “advisers to private funds” or “advisers to family offices.” That’s because while these and other common species of investment advisers are exempt from registering with the SEC, they are still investment advisers, which means (1) they are still subject to certain legal obligations, and (2) they still might have to register with a state. More on all that later.

Questions? Let me know.

Think Twice About a Low Target Amount in Title III Crowdfunding

Target amount in Title III Crowdfunding

Many Title III issuers are setting “target amounts” as low as $10,000. I understand the motivation, but I’d urge issuers and the platforms to think twice.

Background

In Title III Crowdfunding (also known as “Regulation Crowdfunding” or “Regulation CF” or “Reg CF”), the issuer establishes a “target amount” for the offering. Once the offering achieves the target amount, the issuer can start spending the money raised from investors, even while continuing to raise more money. That gives issuers a strong incentive to set a low target amount.

EXAMPLE:  A brewery needs to raise $400,000 for equipment, fit-out, marketing, and salaries. If the brewery establishes $400,000 as the target amount, it can’t start spending the money from investors until it raises the entire $400,000. If it establishes $10,000 as the target amount, on the other hand, it can start spending investor money as soon as it raises the first $10,000 — even if the business will fail without the full $400,000.

The platform benefits, also, in two ways:

  • If the brewery establishes a target amount of $10,000 and raises at least that much, the platform can include the brewery in its “Reached Target Amount” list, even if overall the brewery raised only $12,000 and failed.
  • The platform receives a commission only on funds released to the issuer. The sooner money is released to the issuer, the sooner the platform earns a commission.

Minimum Offering Amounts

Target amounts were around long before Title III Crowdfunding, in the form of “minimum offering amounts.” A company raising capital would establish a “minimum offering” equal to the lowest amount of money that would make the business viable. If a brewery absolutely needs $400,000 to be viable, then the minimum offering would be $400,000. If it could plausibly scrape by with $315,000 — maybe by deferring the purchase of an $85,000 piece of equipment — then the minimum offering would be $315,000.

Issuers don’t establish minimum offerings because they want to, but because experienced investors won’t invest otherwise. If $315,000 is the minimum that will make the brewery successful, an experienced investor writing the first check will demand that her money be held in escrow until the offering raises $315,000. If the offering doesn’t raise $315,000, she gets her money back. Investing is hard enough:  why invest in a company that’s guaranteed to fail?

That’s also why we have traditionally seen “minimum/maximum” offerings. The brewery that needs at least $315,000 to be viable might be able to make great use of up to $475,000, with both numbers anchored to a believable business plan.

The Decision in Title III

Cash is king for most entrepreneurs, the sooner the better, so a Title III issuer will be tempted to establish a low target amount. And to the extent an issuer can rely on inexperienced investors, it might be successful, at least in the short term.

But the issuer should also be aware of the downside:  by establishing a low target amount, the issuer is driving away experienced investors. How many experienced investors are driven away, and the amount they might have invested, can’t be captured.

On the positive side, an issuer that establishes a realistic target amount can and should advertise that fact in its Form C, perhaps drawing a favorable contrast vis-à-vis other Title III issuers, whose target amounts were picked from the air. That’s the kind of information an experienced investor will like to see.

An issuer that weighs the pros and cons and nevertheless decides on an artificially low target amount should include a prominent risk factor in its Form C:

“The ‘target amount’ we established for this offering is substantially lower than the amount of money we really need to execute our business plan. If we raise only the target amount and are unable to raise other funds, our business will probably fail and you will lose your entire investment.”

Artificially low target amounts carry a long-term downside for the platform, too. I would argue that as long as issuers are establishing $10,000 minimums, Title III won’t be taken seriously as an asset class, and the industry won’t grow.

Questions? Let me know.

Podcast: The BAD Crypto Podcast – Crowdfunding Law with Mark Roderick

Mark Roderick Crowdfunding Attorney

Recently, BAD Crypto Podcast hosts Joel Comm and Travis Wright were foolish enough to have me on their show, talking about Crowdfunding and Crypto and ICOs and blockchain and French cooking (or was that another podcast?). Click here to listen.

I hope it was informative – it was definitely fun.

Questions? Let me know.

Non-U.S. Investors and Companies in U.S. Crowdfunding

Non-US Investors and Companies in US Crowdfunding

When I was a kid, back in the 1840s, we referred to people who live outside the United States as “foreigners.” Using the more globalist and clinical term “non-U.S. persons,” I’m going to summarize how people and companies outside the U.S. fit into the U.S. Crowdfunding and Fintech picture.

Can Non-U.S. Investors Participate in U.S. Crowdfunding Offerings?

Yes. No matter where he or she lives, anyone can invest in a U.S. Crowdfunding offering, whether under Title II, Title III, or Title IV.

The Crowdfunding laws don’t distinguish U.S. investors from non-U.S. investors. Thus:

  • To invest in an offering under Title II (SEC Rule 506(c)), a non-U.S. investor must be “accredited.”
  • If a non-U.S. investor invests in an offering under Title III (aka “Regulation CF”), he or she is subject to the same investment limitations as U.S. investors.
  • If a non-U.S. investor who is also non-accredited invests in an offering under Tier 2 of Title IV (aka “Regulation A”), he or she is subject to the same limitations as non-accredited U.S. investors, e., 10% of the greater of income or net worth.

What About Regulation S?

SEC Regulation S provides that an offering limited to non-U.S. investors is exempt from U.S. securities laws. Mysterious on its face, the law makes perfect sense from a national, jurisdictional point of view. The idea is that the U.S. government cares about protecting U.S. citizens, but nobody else.

EXAMPLE:  If a U.S. citizen is abducted in France, the U.S. military sends Delta Force. If a German citizen is abducted in France, Delta Force gets the day off to play volleyball.

Regulation S is relevant to U.S. Crowdfunding because a company raising money using Title II, Title III, or Title may simultaneously raise money from non-U.S. investors using Regulation S. Why would a company do that, given that non-U.S. investors may participate in Title II, Title III, or Title IV? To avoid the limits of U.S. law. Thus:

  • A company raising money using Title II can raise money from non-accredited investors outside the United States using Regulation S.
  • A company raising money using Title III can raise money from investors outside the United States without regard to income levels.
  • A company raising money using Tier 2 of Title IV can raise money from non-accredited investors outside the United States without regard to income or net worth.

Thus, a company raising money in the U.S. using the U.S. Crowdfunding laws can either (1) raise money from non-U.S. investors applying the same rules to everybody, or (2) place non-U.S. investors in a simultaneous offering under Regulation S.

What’s the Catch?

The catch is that the U.S. is not the only country with securities laws. If a company in the U.S. is soliciting investors from Canada, it can satisfy U.S. law by either (1) treating the Canadian investors the same way it treats U.S. investors (for example, accepting investments only from accredited Canadian investors in a Rule 506(c) offering), or (2) bringing in the Canadian investors under Regulation S. But to solicit Canadian investors, the company must comply with Canadian securities laws, too.

Raising Money for Non-U.S. Companies

Whether a non-U.S. company is allowed to raise money using U.S. Crowdfunding laws depends on the kind of Crowdfunding.

Title II Crowdfunding

A non-U.S. company is allowed to raise money using Title II (Rule 506(c)).

Title III Crowdfunding

Only a U.S. entity is allowed to raise money using Title III (aka “Regulation CF”). An entity organized under the laws of Germany may not use Title III.

But that’s not necessarily the end of the story. If a German company wants to raise money in the U.S. using Title III, it has a couple choices:

  • It can create a U.S. subsidiary to raise money using Title III. The key is that the U.S. subsidiary can’t be a shell, raising the money and then passing it up to the parent, because nobody wants to invest in a company with no assets. The U.S. subsidiary should be operating a real business. For example, a German automobile manufacturer might conduct its U.S. operations through a U.S. subsidiary.
  • The stockholders of the German company could transfer their stock to a U.S. entity, making the German company a wholly-owned subsidiary of the U.S. entity. The U.S. entity could then use Title III.

Title IV Crowdfunding

Title IV (aka “Regulation A”) may be used only by U.S. or Canadian entities with a “principal place of business” in the U.S. or Canada.

(I have never understood why Canada is included, but whatever.)

If we cut through the legalese, whether a company has its “principal place of business” in the U.S. depends on what the people who run the company see when they wake up in the morning and look out the window. If see the U.S., then the company has it’s “principal place of business” in the U.S. If they see a different country, it doesn’t. (Which country they see when they turn on Skype doesn’t matter.)

Offshore Offerings

Regulation S allows U.S. companies to raise money from non-U.S. investors without worrying about U.S. securities laws. But once those non-U.S. investors own the securities of the U.S. company, they have to think about U.S. tax laws. Often non-U.S. investors, especially wealthy non-U.S. investors, are unenthusiastic about registering with the Internal Revenue Service.

The alternative, especially for larger deals, is for the U.S. entity to form a “feeder” vehicle offshore, typically in the Cayman Islands because of its favorable business and tax climate. Non-U.S. investors invest in the Cayman entity, and the Cayman entity in turn invests in the U.S. entity.

These days, it has become a little fashionable for U.S. token issuers to incorporate in the Cayman Islands and raise money only from non-U.S. investors, to avoid U.S. securities laws. Because the U.S. capital markets are so deep and the cost of complying with U.S. securities laws is so low, this strikes me as foolish. Or viewed from a different angle, if a company turns its back on trillions of dollars of capital to avoid U.S. law, I’d wonder what they’re hiding.

What About the Caravan from Honduras?

Yes, all those people can invest.

Questions? Let me know.

The IRS Regulations on Qualified Opportunity Zone Funds

Qualified Opportunity Zone Funds

The Internal Revenue Service just issued regulations about qualified opportunity zone funds, answering many of the questions raised by the legislation itself. And for the most part, the answers are positive for investors and developers.

Can I Use An LLC?

Yes. Although the legislation provides that a QOZF must be a “corporation or a partnership,” the regulations confirm that a limited liability company treated as a partnership for tax purposes (or any other entity treated as a partnership for tax purposes) qualifies.

How Do I Calculate Rehabilitation Costs?

To qualify as “qualified opportunity zone business property,” either the original use of the property must begin with the QOZF or the QOZF must “substantially improve” the property. The statute says that to “substantially improve” the property, the QOZF must invest as much in improving the property as it paid for the property in the first place.

The regulations carve out an important exception: in calculating how much the QOZF paid for the property, the QOZF may exclude the cost of the land. Thus, a QOZF that buys an apartment building for $2,000,000, of which $1,500,000 was attributable to the cost of the land, is required to spend only $500,000 on renovations, not $2,000,000.

What Kind of Interest Must an Investor Own?

To obtain the tax deferral, an investor must own an equity interest in the QOZF, not a debt instrument. Preferred stock is usually treated as an equity interest.

Are Short-Term Capital Gains Covered?

Yes, all capital gains are covered. Ordinary income — for example, from depreciation recapture — is not.

Do All The Assets of the Business Have to be in the Qualified Opportunity Zone?

A business can qualify as a “qualified opportunity zone business” only if “substantially all” of its tangible assets are located in the qualified opportunity zone. The regulations provide that “substantially all” means at least 70%. That means that 30% of the assets of the qualified opportunity zone business can be outside the qualified opportunity zone.

NOTE:  Don’t get confused. To qualify as a QOZF, the fund itself must have invested 90% of its assets in “qualified opportunity zone property.” One kind of of “qualified opportunity zone property” is a “qualified opportunity zone business.” The 70/30 test applies in determining whether a business is a “qualified opportunity fund business.” So if a QOZF owns assets directly, 90% of those assets must be in the qualified opportunity zone. But if the QOZF invests in a business, then only 70% of the assets of the business must be in the qualified opportunity zone.

NOTE:  Many QOZFs will own property through single-member limited liability companies. When applying the 70% test and the 90% test, bear in mind that a single-member limited liability company is generally not treated as a “partnership” for tax purposes, but rather as a “disregarded entity.” For tax purposes, assets owned by the single-member limited liability company will be treated as owned directly by the QOZF.

What Happens in 2028, When the Program Ends?

The qualified opportunity zone program ends in 2028. Nevertheless, the regulations allow investors to continue to claim tax benefits from the program until 2048.

How Long can the QOZF Wait to Invest?

Suppose a QOZF raises $5M today. When does the money have to be invested?

The regulations provide that under some circumstances, you can wait up to 31 months to invest. But this is one area where more guidance is needed.

Questions? Let me know.

Help Wanted

help wantedMy work in the Crowdfunding space has been the most interesting and challenging of my career. Now I’m looking to add to our Crowdfunding team here at Flaster/Greenberg, and I hope you can help find the right person.

The right person would have these qualifications:

  • An attorney with 2-4 years of experience in corporate and securities offerings
  • Crowdfunding-specific experience appreciated but not required
  • A good, fast learner, unafraid to ask questions
  • Someone who pays attention to detail, and takes pride in great legal work
  • A good writer and communicator
  • Good technology skills
  • Lives in the Philadelphia area or is able to work effectively remotely

If you or someone you know has these qualifications, please forward a resume to our Human Resources Director, Karen Roberts, at Karen.Roberts@flastergreenberg.com.

Thank you!

MARK

Questions? Let me know.

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