Carrier Channel: SEC: Enron Broadband A Fairy Tale

Posted: 7/2003

SEC: Enron Broadband A Fairy Tale

By Josh Long

January 2000, Wall Street was so enamored with the broadband services unit of
Enron Corp. that its shares rose 36 percent one day after executives gloated
over its ability to connect with every network in the world and deliver advanced
capabilities that would pave the way for a new business: bandwidth trading.

In reality, Enron engineers faced huge challenges
designing a broadband network that its executives repeatedly told analysts it
already had completed, according to the Securities & Exchange Commission,
which has brought a mountain of civil charges against former Enron Broadband
Services Inc. (EBS) executives.

The Department of Justice also has filed criminal
charges against these same people. All seven individuals have pleaded not
guilty, according to a DOJ spokesman. Other former Enron employees also are
named in the criminal indictment, including former CFO Andrew Fastow.

The broadband network, according to the
government agencies, simply could not do all the things Enron claimed, including
bill telecom carriers only for the bandwidth they used.

On May 1 the SEC filed an amended complaint in
U.S. District Court in Houston, charging five former executives of Enron
subsidiary EBS with violating the antifraud provisions of federal securities
laws and pocketing more than $150 million in unlawful profits through stock
sales. Those named in an amended complaint include Ken Rice, former chairman and
co- CEO; Joseph Hirko, former president and co- CEO; Kevin Hannon, former COO;
Rex Shelby; former senior vice president; and F. Scott Yeager, former senior
vice president.

The agency also has filed charges against former
EBS executives Kevin Howard and Michael Krautz for their involvement in the
creation of a joint venture called Project Braveheart. The joint venture, the
SEC says, was set up to fraudulently generate earnings in the wake of an
agreement with Blockbuster Inc. to deliver video-on-demand movies to desktops.

The SEC alleges that over a two-year period these
people told the public repeatedly the network could deliver state-of-the-art
applications, such as the ability to reserve bandwidth for a specified time,
when they knew their engineers were having trouble delivering on the promises.

Less than three years after announcing the
broadband network was complete and ready for business, Enron restructured its
broadband unit. Two months later, the company filed for bankruptcy. At the time
it marked the largest bankruptcy filing in U.S. history and one of the largest
corporate scandals.

At a point when Enrons touted
groundbreaking technology was little more than a concept and its business model
was not commercially viable these defendants played important roles in
perpetuating the fairy tale that Enron was capable of spinning straw or more
appropriately, fiber into gold, said Linda Chatman Thomsen, SEC deputy
director of the division of enforcement.

In April 1999, Enron announced its network,
including the network control software created to revolutionize the way carriers
bought and sold bandwidth, was complete. Enron said the network was ready to
deliver a streaming service (Media Cast) tailored to deliver video to the
desktop and a service (Media Transport) designed to deliver large video data
files across the network at guaranteed service levels, according to the SEC.

EBS engineers, the agency charges, said the
software could not do what the Enron executives claimed. The executives had
knowledge the software intelligence was incomplete through weekly staff meetings
with engineers, conversations with EBS executives and employees and e-mail
messages, according to the amended complaint. As of January 2000, the software
still was undergoing the planning and specifications phase, according to the

The proposed intelligence in the EIN (Enron
Intelligent Network) had become a running joke throughout the organization
because of the inability to deliver anything that worked as promised, the
complaint states. Morale at EBS was poor and key engineers were threatening
to quit.

At an equity conference that month, Enron
executives praised the network and said Enron had fiber internationally and the
ability to link with every network in the world, according to the SEC.

Shelby, the government agency notes, said Enrons
software control layers had not only been embedded in its own network, but in
the networks of customers and other telecom companies. Enron, the
complaint states, did not have the software described by Shelby.

The government says Wall Street analysts walked
away from the presentation impressed. One day before the conference, Enrons
stock price was $53. The date of the conference Enron shares closed at $67, and
the price swelled to $72 the following day.

Following the conference, equity analysts from
the major Wall Street brokerage firms erroneously concluded that Enron possessed
ground-breaking network control software, providing it with … advanced
capabilities, enormous market advantage and the ability to trade bandwidth,
the complaint states.

Less than two weeks later, according to the SEC,
Enron executives attended a meeting in Arizona in which they discussed significant
problems with EBS products, service, revenue and development.

EBS posted no recurring revenue in 2000; it
generated income through one-time asset sales and swaps, including the
fraudulent joint venture Project Braveheart, according to the SEC. In November
2000 Hannon retained a consultant to review EBS. The consultant concluded
that in 2000 EBS had very little business and the prospects for 2001 did not
look promising, according to the complaint.

Rice had an employee value EBS. The employee,
according to the SEC, valued the content portion of EBS at $8 billion. Upon
reviewing the valuation, Rice informed the employee who prepared it that he
would not present a valuation that was less than $18 billion the valuation
presented the year before at the 2000 analyst conference, according to the
amended complaint. Rice instructed the employee to redo the valuation and to
make sure that it was more than $18 billion. Rice was subsequently given a
valuation of $21 billion for EBS content business, a valuation Rice provided
at the analyst conference.

On Jan. 22, 2001, three days before Enrons
analyst conference, Rice and Hannon learned that EBS, according to estimates,
would incur losses of more than $149 million in the first quarter, the complaint

During the conference, Rice repeatedly said
Blockbuster was Enrons anchor tenant and that the agreement was a
20-year deal even though he knew Enron had materially breached the
Blockbuster contract in December 2000 and was likely to terminate in March 2000,
according to the complaint.

EBS inked the Blockbuster agreement in April
2000. At the time Enron did not have the technology to provide video-on-demand,
according to the SEC. The government says Blockbuster warned it could take years
to be granted the rights to distribute the movies digitally over the Internet
because the studios were concerned over pirating and obtaining a revenue share.

~The End~


Blockbuster Inc.

Enron Corp.

U.S. Department of Justice

U.S. Securities & Exchange Commission


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