UNITED STATES DISTRICT COURT
Plaintiff Securities and Exchange Commission (the "Commission") for its First Amended Complaint alleges as follows:
1. This case involves a scheme to defraud, and resulting unlawful profits of over $155 million, by Kevin P. Hannon, Joseph Hirko, Kevin A. Howard, Michael W. Krautz, Kenneth D. Rice, Rex T. Shelby, and Scott Yeager, all former executives and employees of Enron Broadband Services, Inc. ("EBS"). The purpose of defendants' scheme was to deceive the investing public and others about the technology, financial condition, performance, and value of EBS. The defendants carried out this scheme to defraud by, among other things: (a) making and causing others to make false and misleading statements in press releases and at analyst conferences, and the omission of material information in such public statements; and (b) transactions whose sole purpose was to generate fraudulent earnings.
2. As part of the scheme, Hannon, Hirko, Rice, Shelby, and Yeager engaged in a scheme to defraud and to manipulate and inflate the value of Enron stock through, in part, the means described above. These defendants profited from this scheme to defraud by selling large amounts of Enron stock at the inflated prices. These trades also occurred while the defendants were in possession of material non-public information, including information that Enron's broadband network did not work as claimed and that the stock price was inflated. The unlawful profits were substantial: Hannon, $8,996,707; Hirko, $52,998,781; Rice, $40,280,215; Shelby $17,540,404; and Yeager $35,117,048.
3. In another part of the scheme to defraud, defendants Howard and Krautz engaged in a scheme that allowed Enron to recognize and publicly report $111 million in fraudulent earnings. The scheme, known as "Project Braveheart," involved the "monetization" of certain assets resulting in the immediate recognition of earnings from a long term agreement with Blockbuster to develop and provide video-on-demand services. Howard and Krautz carried out the scheme by forming a purported joint venture, assigning the Blockbuster agreement to the joint venture, and selling an interest in the joint venture based on the value of future revenues from the Blockbuster agreement to a third party. As a result, EBS recognized $53 million in earnings in the fourth quarter 2000 and $58 million in earnings in the first quarter 2001, thus enabling EBS to meet its earning targets.
4. Project Braveheart was a sham from its inception. The transaction had no economic substance and was created solely for the purpose of generating earnings. The joint venture partner was an entity that never intended to participate as a partner, and its equity was not at risk because Enron guaranteed the entity a short term take-out at a specified rate of return.
As a result of the unlawful conduct of Howard and Krautz, Enron filed periodic public reports, and accompanying public statements, that were materially false and misleading.
5. Defendants violated the antifraud provisions of the federal securities laws, and the Commission seeks from each disgorgement of unlawful gains, civil penalties, a permanent injunction, and an officer and director bar.
JURISDICTION AND VENUE
6. The Court has jurisdiction over this action pursuant to Sections 21(d), 21(e), and 27 of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78u(d) and (e) and 78aa] and Sections 20(b), 20(d)(1) and 22(a) of the Securities Act of 1933 ("Securities Act") [15 U.S.C. §§ 77t(b), 77t(d)(1) and 77v(a)].
7. Venue lies in this District pursuant to Section 27 of the Exchange Act [15 U.S.C. § 78aa] and Section 22 of the Securities Act [15 U.S.C. § 77v(a)] because certain acts or transactions constituting the violations occurred in this District.
8. In connection with the acts, practices, and courses of business alleged herein, defendants, directly or indirectly, made use of the means and instruments of transportation and communication in interstate commerce, and of the mails and of the facilities of a national securities exchange.
9. Defendants, unless restrained and enjoined by this Court, will continue to engage in transactions, acts, practices, and courses of business as set forth in this Complaint or in similar illegal acts and practices.
10. Kevin A. Howard resides in Houston, Texas. Howard was Vice President for Finance of EBS from approximately August 1, 1999 to September 2001. Howard was the senior EBS executive who supervised all aspects of the Braveheart transaction. Howard was fired by Enron on March 12, 2003, the same day the Complaint in this matter was filed.
11. Michael W. Krautz resides in Houston, Texas. Krautz was Senior Director of Transactional Accounting at EBS from approximately August 16, 1999 to October 3, 2001. Krautz was the senior EBS accountant who worked on the Braveheart transaction. Krautz was fired by Enron on March 12, 2003, the same day the Complaint in this matter was filed.
12. Kevin P. Hannon resides in Houston, Texas. Hannon was President and Chief Operating Officer of EBS from February 2000 to June 2001.
13. Joseph Hirko is a resident of Portland, Oregon. Hirko was Chairman and CEO of EBS from February 2000 to July 2000, Co-Chairman and CEO from June 1999 to February 2000, and CEO of Enron Communications, Inc. (EBS'predecessor entity) from January 1998 until June 1999.
14. Kenneth D. Rice is a resident of Bellaire, Texas. Rice was Chairman and CEO of EBS from June 2000 until August 2001, Chief Commercial Officer from February 2000 to June 2000, and Co-Chairman and CEO from June 1999 to February 2000. Rice asserted his Fifth Amendment rights in Commission testimony.
15. Rex T. Shelby is a resident of Houston, Texas. Shelby was Senior Vice President of Engineering and Operations for EBS from January 1, 1999 to October 1999, Managing Director of EBS from October 1999 to September 2000, and Managing Director of Enron Networks from September 2000 to November 2001. Shelby asserted his Fifth Amendment rights in Commission testimony.
16. Scott Yeager is a resident of Sugarland, Texas. Yeager was Senior Vice President for Business Development, Sales and Marketing at EBS from October 1998 to August 2001. Yeager asserted his Fifth Amendment rights in Commission testimony.
OTHER ENTITIES INVOLVED
17. Enron Corp. is an Oregon corporation with its principal place of business in Houston, Texas. During the relevant time period, the common stock of Enron was registered with the Commission pursuant to Section 12(b) of the Exchange Act and traded on the New York Stock Exchange. In 1999-2001, while defendants engaged in the fraudulent conduct alleged herein, Enron raised millions in the public debt and equity markets. Among other operations, Enron was the nation's largest natural gas and electric marketer with reported annual revenue of more than $150 billion. Enron rose to number seven on the Fortune 500 list of companies. By December 2, 2001, when it filed for bankruptcy, Enron's stock price had dropped in less than a year from more than $80 per share to less than $1.
18. Enron Broadband Services, Inc. ("EBS") was a wholly- owned subsidiary of Enron engaged in the telecommunications business. Prior to January 2000, EBS was called Enron Communications, Inc. or "ECI."
Defendants' Fiduciary Duties To Enron And Its Shareholders
19. Hannon, Hirko, Rice, Shelby, and Yeager signed employment agreements with Enron in which they acknowledged and agreed that they owed a duty of trust and confidence to Enron and that personal use of confidential information of Enron was prohibited. Each of these defendants agreed they owed a fiduciary duty to act only in the best interests of Enron and its shareholders. The employment agreements signed by these defendants were in effect during the time period relevant to the First Amended Complaint.
Stock Price Manipulation and Insider Trading (Hannon, Hirko, Rice, Shelby, and Yeager)
Enron's Telecommunications Business Plan
20. In 1998 Enron decided to enter the telecommunications business on a large scale. Yeager proposed that Enron build an advanced software-driven broadband "intelligent" telecommunications network, (aka "Enron Intelligent Network" or "EIN") that could deliver advanced telecommunications applications, including media streaming, video transport services, and video conferencing. Hirko backed the proposal, and Shelby was hired to help implement the plan. The plan required the development of a sophisticated network control software, also known as a software control layer, that would be embedded in the network's routers and servers and other pieces of hardware, giving the network advanced data control and monitoring capabilities. This "intelligent network" would give Enron a market advantage over other telecommunications providers. Enron believed that a messaging software called InterAgent (obtained by Enron through an acquisition) could form a foundation for the network control software necessary for the EIN. The network control software was later renamed the Broadband Operating System or "BOS." Developing the software to drive an intelligent network was an immense engineering challenge.
1999 Press Releases
21. Beginning in 1999, Enron made false and misleading statements about its broadband network in several press releases. As detailed below, certain defendants issued or caused to be issued these releases. With respect to the 1999 releases, Hirko, Rice, Shelby, and Yeager were aware of the content of the releases and knew at the time of publication of the false and misleading statements set forth therein. On April 19, 1999, Enron announced in a press release that the plan for the EIN had been executed. The press release was headlined "Enron Intelligent Network Lit, Tested and Ready to Deliver New World Internet Applications." The press release announced that Enron's broadband network, including the network control software, was completed and ready for business. Hirko, Shelby, and Yeager reviewed the press release and provided input on its content before its publication, and caused its publication.
22. Among other things, the April 19, 1999 press release stated that: (1) the EIN was "lit and ready" to deliver two products, Media Cast and Media Transport;1 (2) "riding on top" of the network was a "control layer" enabled by InterAgent, which was "embedded on every server in the EIN and on the servers of Enron Communication's distribution channels"; (3) this control layer allowed Enron to provide very advanced network features, including "usage-based metering and billing" and "user-defined quality of service"; and (4) the resulting network was "highly reliable" and almost totally automated, "self-managing," and "self-restoring." The press release included a quote from Hirko that he had provided. Hirko claimed that the EIN had "virtually unlimited bandwidth and built-in intelligence," and provided "a highly reliable pay-for-what-you-need, bandwith-on-demand way" to deliver opportunities over the network.
23. The capabilities Enron claimed it possessed in this press release would, if they existed, give the company a market advantage over its competitors. The term "usage-based metering and billing" means that the Enron software could purportedly monitor and measure the precise amount of bandwidth capacity used by a customer and bill only for that amount. If Enron had this capability, it could offer companies the opportunity to pay only for the bandwidth they used, instead of paying for large blocks of capacity regardless of use, which was the industry standard at the time. In short, this capability would give Enron the ability to price broadband contracts more efficiently that its competitors.
24. The term user-defined, tiered, or differentiated "quality of service" or "QOS" means that Enron's software could purportedly allow customers to chose between different levels of service, so that customers with relatively simple data delivery needs, like e-mail, could choose a low and relatively inexpensive quality of service, while customers with sensitive or data-rich files could choose more expensive, higher quality delivery. Again, this capability, if it existed, would give Enron the ability to price contracts more efficiently that its competitors. The term "forward bandwidth reservation" meant the ability to reserve bandwidth capacity for use at a specified time. If a customer wanted to send an application that required a high quality of service, it could reserve bandwidth for a time when the system was less congested and the bandwidth less expensive.
25. The capabilities Enron announced it possessed -- usage-based metering and billing and user-defined or tiered quality of service -- were valuable in their own right. Moreover, they were essential to Enron's larger strategic goal: the creation of a market in tradeable bandwidth capacity. In order to turn bandwidth capacity into a commodity, Enron needed the ability to measure and control the quantity and quality of the capacity to be traded. The April 19, 1999 press release stated that Enron had these capabilities, making the possibility of bandwidth trading market a reality.
26. The statements in the April 19, 1999 press release about EIN and its capabilities were false and misleading. EIN did not have "built-in intelligence," and the network could not perform the services referenced in the press release.
27. After the April 19, 1999 press release, Enron issued additional press releases touting its intelligent network despite the fact that, as indicated above, it had no software control layer or built-in intelligence. For example, on May 11, 1999 and May 20, 1999, Enron issued press releases stating that Enron's network was intelligent and provided, among other capabilities, "tiered" or differentiated quality of service and capacity that could "be purchased entirely on an as-used basis." These statements were false and misleading.
28. Enron continued to release false and misleading press releases in the fall of 1999, despite a lack of material progress on the network software. On September 23, 1999, Enron issued a press release announcing that it had streamed the Country Music Awards via Media Cast over the Enron Intelligent Network. Hirko reviewed this press release prior to publication and caused its release. In the press release, Enron claimed that EIN was a reliable platform that provided bandwith "on demand" and "tiered QOS, data, application and context capabilities purchased entirely on an as-used basis." These statements were false and misleading.
29. On October 26, 1999, Enron issued a press release stating that Enron's intelligent network had "embedded software intelligence that sets it apart from other network providers." This statement was false and misleading. Shelby and Yeager reviewed this press release prior to publication and provided input on the statements regarding the EIN. Hirko and Rice also reviewed the press release prior to publication. Hirko, Rice, Shelby, and Yeager caused the release to be issued.
30. In a press release dated November 10, 1999, Hirko stated that EBS was transmitting video transport and video conferencing, another application, with high quality and reliability over the EIN. This statement was false and misleading. Hirko caused the release to be issued.
31. According to EBS engineers, InterAgent could not perform the functions Hirko, Rice, Shelby, Yeager, Enron, and others claimed it could perform. For example, the network had no "built-in-intelligence." Media Cast was not a new technology, but simply a streaming service run on off-the-shelf software and not on InterAgent. Media Transport did not work and was never made commercially available. Video conferencing was only in the early development stage as late as November 1999, and was ultimately abandoned because it did not work.
32. Hirko, Rice, Shelby, and Yeager knew that development of EIN's software intelligence was incomplete, and that the EIN could not perform the tasks that they and Enron had claimed. These defendants learned of these facts, in part, by participating in weekly staff meetings with engineers, direct conversations with numerous EBS executives and employees, and e-mail messages. Additional facts establishing defendants' knowledge regarding the true state of the BOS and EIN are detailed below.
Summary of the Stock Price Manipulation Aspect of the Scheme
33. Beginning no later than April 1999, with knowledge that the BOS and EIN technology was under development and did not work, Hirko, Rice, Shelby, and Yeager engaged in a scheme to defraud and to manipulate the price of Enron stock. Hannon joined the fraudulent scheme and participated in it beginning in February 2000. These defendants profited from the scheme to defraud by selling Enron stock that they knew was inflated by the scheme.
34. At the same time, Hannon, Hirko, Rice, Shelby, and Yeager sold Enron stock while in possession of material non-public information, including information that the technology did not work as claimed, that EBS' value, revenue, and business performance was poor, and that Enron's stock price was fraudulently inflated. These defendants knew or were reckless in not knowing that the information was confidential and that trading while in possession of that information was a breach of a fiduciary duty or similar relationship of trust and confidence that they owed to Enron and its shareholders.
The January 20, 2000 Analyst Conference
Analyst Conference Preparations
35. Enron's senior management, Hirko, and Rice decided to feature EBS and the EIN technology at Enron's January 20, 2000 analyst conference. Enron featured EBS because it believed that EBS would have the greatest effect on Enron's stock price. Shelby advised his staff in early November 1999 of Enron's plan to highlight EBS at the analyst conference.
36. In late November 1999, Hirko, Rice, Shelby, Yeager, and others began meeting on a weekly basis to help develop ECI's business strategy and message, and to prepare for the January 20, 2000 analyst conference.
37. A major issue for the defendants planning the conference was dealing with the issue of the software for the EIN, which was still in the early stages of development. Hirko, Rice, Shelby, Yeager, and others decided to market the software as the Broadband Operating System, or "BOS," and to claim the software was completed and working, even though this claim was false. The BOS was supposed to be complex intelligent software that would control broadband networks in the same way that Microsoft Windows controls personal computers, allowing multiple applications developed by outside vendors to run seamlessly on the network.
38. Hirko, Rice, Shelby, and Yeager knew that the BOS was under development and not completed, and was not operating on Enron's network. On November 30, 1999, outside consultants met with Rice and others. The participants discussed the fact that the software for the EIN was under development and not complete, and many capabilities were not yet available.
39. During meetings to prepare for the analyst conference, it was made clear that BOS was still under development. For example, in a meeting on December 8, 1999, attended by Hirko, Rice, Shelby, Yeager, and others, the participants discussed the fact that certain BOS functions, such as dynamic routing, dynamic reconfiguration, and forward bandwidth reservation, would not be available until mid-2000, and that a software solution was still being developed. According to outside consultants and another EBS executive who attended these meetings, they understood that the EIN software was still under development.
40. As of January 2000, the software for the intelligent network was still in the planning and specifications phase. The fact that the EIN/BOS software was still in the specification phase in late 1999 and January 2000 has been extensively corroborated by a large number of e-mails exchanged by Shelby's staff, which shows ongoing discussions about specifications for the software and plans to have the software operational some time in 2001. Further, the proposed intelligence in the EIN had become a running joke throughout the organization because of the inability to deliver anything that worked as promised. Morale at EBS was poor and key engineers were threatening to quit.
41. Drafts of a PowerPoint presentation for the January 20, 2000 analyst conference further demonstrate that Hirko, Rice, Shelby, Yeager, and others knew that BOS was not completed and working, and despite this knowledge they intended to make or cause to be made false and misleading statements about BOS. Drafts were circulated to these defendants in early January 2000 stating that the BOS and related software was under development and would not be available until a future date, as late as the third quarter of 2003. The drafts were progressively edited to remove all words indicating that the BOS was under development and would not be available until a future date.
42. In the PowerPoint presentation actually shown by Hirko, Rice, Shelby, Yeager, and others at the January 20, 2000 analyst conference, the information from the early drafts reflecting the true state of the development of the BOS and related software had been eliminated, and was not disclosed at the conference.
False Statements Made At The January 20, 2000 Analyst Conference
43. On January 20, 2000, Enron unveiled its telecommunications strategy at its annual equity analysts conference. Hirko, Rice, and Shelby, among others, made false and misleading statements about the BOS and EIN technology at the conference. Yeager attended the conference and was introduced as EBS' "network strategy guru." By his involvement in the preparations for the conference, Yeager caused others to make statements about the BOS and EIN technology that he knew to be false and misleading, and said nothing to correct such statements.
44. Hirko stated that Enron had fiber internationally, servers deployed on the Enron network, and the ability to connect with every other network in the world. Hirko also stated that software had been developed by EBS that had capabilities to, among other things, connect servers and deliver services. Hirko's statements were false and misleading. Enron did not have the software or the software-driven capabilities Hirko described.
45. Shelby made false and misleading statements at the analyst conference by video presentation. Shelby discussed at length the "EIN software layer." Shelby stated that the software linked together all of the hardware on the network, such as servers and routers, as well as all of the software elements, including a security system and a bandwidth reservations system. Shelby stated that this software control layer allowed Enron to change the behavior of the hardware and software elements in the network in real time, by sending control signals to these elements. Shelby also stated that this control layer had been embedded not only in Enron's network, but in the networks of customers and other telecommunications companies. Shelby's statements were false and misleading. Enron did not have the software described by Shelby.
46. After the Shelby video, Hirko made additional false and misleading statements. Hirko stated: "this software layer, is this a pipedream, is this something that we're going to get done in the next five years? No, this is something that exists today." Hirko stated that Enron had "a software layer that exists today that's capable of providing control of our network, our network of networks and delivering a quality of service for the Internet that has not been possible to date." Hirko also stated that Enron could "deliver an Internet experience that has quality of service that's appropriate for the content being transmitted. It basically allows us to achieve the vision of the Internet that was never possible because of the way it was originally architected." Hirko's statements were false and misleading because the software layer he described did not exist and was not controlling Enron's network.
47. Shelby made additional false and misleading statements about BOS in his video presentation: "We talked earlier about the four major components of the Enron Intelligent Network. These components are the fiber, the servers, the pooling points and the software layer. The software layer is really the major element of Enron's Broadband Operating System, or what we call the BOS. The BOS is really the master control system for the entire Enron network. We like to say that the BOS is the `I' in EIN because it's the element that provides the intelligence to the Enron network." In addition, Shelby claimed that BOS was linked to all elements of the network, including the physical devices and software components in the network. He also stated "the BOS can actually receive information from these network components and by doing that can monitor the activities in the network. On the other hand, the BOS can send control signals to any of the components in the network and change their behavior in real time." These statements were false and misleading.
48. Rice stated that the EIN could identify which applications required a higher quality of service and that it could route applications based on the quality of service required for the application. Rice also stated that Enron had its own "proprietary" software that allowed it to switch customers between its broadband network and other networks. These statements were false and misleading.
49. Shelby also made the following false and misleading statements about the "capabilities" that "the BOS provide[d] to Enron and to the industry":
Effect on Enron's Stock Price
50. Analysts and investors reacted favorably to the presentation crafted and delivered by Enron, Hirko, Rice, Shelby, and Yeager about EBS. On January 19, 2000, the day before the analyst conference, the stock price was $53. On January 20, 2000, the date of the analyst conference, the closing price increased to $67. The day after the analyst conference, the price increased to $72. The volume of trading in Enron shares also increased dramatically, from 2,828,200 shares the day before the analyst conference, to 13,482,000 shares the day after the analyst conference.
51. As a result of the scheme to defraud and the false and misleading statements made in press releases and at the analyst conference, equity analysts from major Wall Street brokerage firms erroneously concluded that Enron possessed ground-breaking network control software, providing it with an advanced capabilities, enormous market advantage, and the ability to trade bandwidth. Hannon, Hirko, Rice, Shelby, Yeager, and others continued the scheme to defraud after the January 20, 2000 analyst conference.
Off Site Meetings, February-March 2000
52. The knowledge of Hannon, Hirko, Rice, Shelby, and Yeager that the BOS was in a developmental stage and did not exist on Enron's network as claimed is also established by events that occurred after the analyst conference.
53. Beginning January 31, 2000, less than two weeks after the analyst conference, Hannon, Hirko, Rice, Shelby, Yeager, and others attended an off-site meeting in Arizona to discuss EBS. The participants discussed, among other things, significant problems with products, service, revenue, and software development. The participants were also reminded of these facts by PowerPoint presentations.
54. For example, an EBS executive made a presentation at the January 31, 2000 off-site meeting which made clear that the network was not enabled with BOS. After the conference, the PowerPoint presentations were sent to Hirko, Howard, Rice, Shelby, Yeager, and others by e-mail.
55. Almost simultaneously with the January 31, 2000 off site meeting, Enron formed a technology steering committee that was responsible for solving the technological problems faced by EBS. The committee included Hannon, Hirko, Rice, Shelby, and Yeager. Hannon chaired the committee. The committee met on a regular basis, discussed the status of the BOS and the lack of progress, and at no time in these meetings was it presented that the BOS was fully developed or that it existed on Enron's network.
56. On March 1-3, 2000, EBS executives had a second off site meeting, attended by Hannon, Hirko, Rice, Shelby, Yeager and others. At the meeting, the parties discussed, among other things, significant problems with EBS, BOS, and the development of EIN's capabilities. The parties also discussed the fact that the first BOS release was not anticipated until September 30, 2000, at the earliest.
57. Rice, Hannon, and Yeager received biweekly management reports which, beginning in September 2000 through at least March 2001, kept track of BOS development and confirmed that the BOS had not been fully developed or released.
False and Misleading Press Releases 2000
58. In 2000, Enron issued a series of press releases in which it made false and misleading statements regarding the BOS and the EIN. The releases described the BOS as the embedded software intelligence that set Enron's network apart from other network providers. The releases claimed, among other things, that the BOS and the EIN provided reliable, tiered or high quality of service; the ability to forward reserve bandwidth; the ability to add network capacity on a real-time basis; application and content capabilities that could be purchased on an as-used basis; and the ability to trade bandwidth. These statements were false and misleading. In addition, the July 19, 2000 press release contained false and misleading statements describing how Enron planned to stream video-on-demand over its network, at a time when the specifications for the delivery platform had not been written, no software existed to deliver the product, and EBS did not have the technological ability to deliver video-on-demand.
59. The releases included those issued on the following dates: January 31, 2000, March 8, 2000, March 30, 2000, April 10, 2000, May 15, 2000, June 29, 2000, and July 19, 2000. Hannon, Hirko, Rice, Shelby, and Yeager were fully aware of the content of the releases as soon as they were published and knew the statements in the releases as set forth herein were false and misleading. Hannon, Hirko, Rice, and Shelby reviewed the March 8, March 30, and April 10, 2000 releases prior to publication and caused Enron to issue the releases. Hannon, Hirko, and Rice reviewed the May 15, and June 29, 2000 press releases prior to publication and caused Enron to issue the releases. Hirko and Rice reviewed the January 31, 2000 press release prior to publication and caused Enron to issue the release. In addition, Enron issued at least 22 press releases in 2000 in which it "introduced" the BOS and claimed falsely that it allowed application developers to dynamically provision bandwidth on demand. With respect to these 22 releases, Rice, Hirko, Hannon, Shelby, and Yeager reviewed some or all of the releases prior to publication, and they knew at the time of publication of the false statements therein.
60. From on or about July 19, 2000 through on or about September 2000, Hannon, Rice, Shelby, and Yeager continued to be regularly informed by EBS engineers via conversations, documents, and meetings that the BOS was not fully functional. From on or about September 2000 through on or about March 2001, Hannon, Rice, and Yeager continued to be regularly informed by documents and other means that the BOS was not fully functional.
The January 2001 Analyst Conference
The Status of EBS' Business
61. Throughout 2000, EBS was unsuccessful in developing the BOS or a network that had any competitive advantage and, as a result, could not secure a significant revenue producing customer base or any real revenue from the network. EBS had no recurring revenues in 2000. Virtually all of its fiscal year 2000 income was generated through one time asset sales and swaps, which included the fraudulent Project Braveheart transaction described below.
62. By the fall of 2000, Rice, Hannon, and others knew that EBS was not a commercial success, had no meaningful recurring revenues, and was experiencing a significant earnings shortfall. On November 20, 2000, Hannon told another EBS' senior executive that EBS was $100 million behind budget and that EBS was clearly struggling. That same executive, and another EBS senior executive, repeatedly warned Rice and Hannon that EBS could not support its cost structure and that EBS needed to cut costs if it could not develop and sell profitable products. The executives also cautioned Rice and Hannon that it would be impossible for EBS to develop its business based on the manner in which it was running the operations. In addition, both Hannon and Rice received management reports on a regular basis which showed that EBS was experiencing significant losses.
63. In November 2000, Hannon retained a consultant to conduct a comprehensive review of EBS' business. On January 16, 2001, the consultant presented Hannon and Rice its initial findings and recommendations. The consultant concluded that in 2000 EBS had very little business and the prospects for 2001 did not look promising.
Preparation for the January 2001 Analyst Conference
64. Rice and Hannon were in charge of the preparation of the EBS portion of Enron's January 2001 analyst conference. Beginning in December 2000, they met regularly to prepare and review the draft presentation. As part of the preparation, Rice and Hannon reviewed outlines and presentation materials and instructed others to include in the presentation materials false and misleading statements about the BOS and bandwidth trading.
65. A valuation of the content services portion of EBS' business was prepared at Rice's direction. EBS' content business was valued 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. 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.
66. On January 22, 2001, three days before Enron's 2001 analyst conference, Rice and Hannon became aware that each of EBS' business units was losing money and that, according to EBS estimates, EBS would incur losses of more than $149 million in the first quarter of 2001.
The False Statements at the January 25, 2001 Analyst Conference
67. At the January 25, 2001 Enron Analyst Conference, Rice and Hannon made a presentation about EBS that included several false and misleading statements, including claims that the BOS existed and operated on Enron's network, and that EBS was a commercial success whose value had increased substantially from the prior year.
68. Rice and Hannon specifically touted the EIN and BOS technology. Rice claimed, among other things, that the BOS had been "deployed," was "up and running," and that it managed and controlled various parts of EBS' network. Rice also claimed that EBS could deliver premium content and bandwidth on a realtime basis. Rice's statements were false and misleading.
69. Hannon also made false and misleading statements about the technology at the analyst conference. Hannon stated, among other things, that "Enron's broadband operating system" allowed customers to select between five different levels of quality of service and that it provided "highly secure" and "guaranteed" delivery." These statements were false and misleading.
70. Rice made several positive statements about the purported commercial success of the business. Rice claimed Enron's commercial model "works better than anyone else's," and that Enron had the "only commercially viable and scalable broadband delivery platform." These statements were false and misleading. Hannon and Rice also knew and failed to disclose at the analyst conference that EBS had virtually no commercial viability, no recurring earnings, and a lack of competitive products.
71. The presentation materials distributed by Rice, Hannon, and others stated, contrary to the consultant's reports, that EBS expected significant growth in the transactions and volume delivered in 2001. The materials also stated that in 2000, EBS successfully demonstrated that Enron's business model could be directly extended to the communications industry and that the opportunity for EBS in broadband was significantly greater than previously anticipated. These statements were false and misleading.
72. Rice also made false and misleading statements about the Blockbuster transaction (detailed below). Rice stated repeatedly that Blockbuster was Enron's "anchor tenant" and that the Enron-Blockbuster deal was a "twenty year" transaction, when Rice fully knew that Enron had materially breached the Blockbuster contract in December 2000 and was likely to terminate in March 2001.
73. Rice concluded by presenting EBS' financials. He stated that Enron was very bullish about EBS' position and growth opportunities in the industry. Rice then valued EBS' intermediation business at $20 billion and content business at $21 billion (the value that Rice had insisted be made greater than the year before), minus $5 billion in expenses, for a total present-day value of $36 billion, or an increase of 20% from the year before. Rice stated that the valuation increased from the prior year because Enron's "ability to take market share . . . seems to be larger than we expected it would be last year." Rice also attributed the valuation to the fact that demand for Enron's premium delivery services was growing. The statements and valuation were false and misleading.
74. Enron and the defendants did not correct any of the false and misleading statements that were made concerning the EBS technology. On October 16, 2001, in its third quarter earnings release, Enron announced a $180 million non-recurring charge associated with EBS' restructuring. The charge included severance costs, loss on the sale of inventory, and an impairment to reflect the reduced value of EBS' content business. On December 2, 2001, after a series of revelations about its business, Enron declared bankruptcy.
Changes in Enron's Stock Price
75. Between April 19, 1999, the date of the first press release, and the January 25, 2001 analyst conference, Enron's stock rose from $34 to $82 per share, an increase of over 140%. Moreover, during this time period, Enron announced a 2-for-1 stock split. From January 25, 2001 to October 16, 2001, the day Enron announced that it was taking a $180 million charge for EBS, Enron's stock gradually declined from a close of $82 to $34 per share.
76. Most notably, Enron's stock experienced some of its most dramatic increases in the days immediately following the analyst conferences. For example, on January 19, 2000, the day before the 2000 analyst conference, the stock closed at $53 a share. On January 21, 2000, the day after the analyst conference, Enron's stock closed at $72, an increase of 33%. In the nine days leading up to the 2001 analyst conference Enron's stock price increased from $68 to $82, an increase of 21%.
Defendants' Profits From The Fraudulent Scheme
77. Hannon, Hirko, Rice, Shelby, and Yeager sold large amounts of Enron stock throughout the period that the scheme to defraud was carried out, while the false and misleading statements were made, and as they engaged in the manipulation of Enron's stock price. As a result of their unlawful conduct, Hannon, Hirko, Rice, Shelby, and Yeager made millions in unlawful gains as set forth below.
78. The information learned by Hannon, Hirko, Rice, Shelby, and Yeager in internal meetings, e-mails, and by other internal means about the BOS, EIN, and EBS' value, business performance, and revenues, was confidential non-public information covered by these defendants' employment agreements and covered by defendants' fiduciary duties to Enron and its shareholders. The trades by Hannon, Hirko, Rice, Shelby, and Yeager occurred while these defendants were in possession of material non-public information as detailed above. These defendants knew or were reckless in not knowing that the information was confidential and that trading while in possession of that information was a breach of a fiduciary duty or similar relationship of trust and confidence that they owed to Enron and its shareholders. As detailed in the attached appendix, incorporated as if fully stated herein, Hannon, Hirko, Rice, Shelby, and Yeager made unlawful gains from their scheme to defraud and from insider trading.
Project Braveheart (Howard and Krautz)
Origin of the Braveheart Transaction
79. On April 5, 2000, EBS signed an agreement with Blockbuster Inc. ("Blockbuster"), the nation's largest retailer of videos for home viewing, to stream video films to customers' homes. Under the agreement, Blockbuster was responsible for obtaining digital rights to film content from film studios and other sources. EBS was responsible for encoding the movies Blockbuster obtained, streaming them over a telecommunications network to customers' homes, and then billing the customers for the service. This business was known as "video on demand," or "VOD," because the customers were supposed to be able to access and watch movies in their homes whenever they wanted. EBS's plan was to begin a test of the VOD service by approximately December 15, 2000.
80. At the time the parties entered into the agreement, EBS did not have the technology to provide VOD over its network. In addition, Blockbuster did not have the rights to distribute first-run movies digitally over the Internet. Blockbuster warned EBS that it could take years to obtain digital rights to first-run movies, as studios were concerned about pirating and obtaining a share of the revenues from VOD.
81. By late summer of 2000, EBS anticipated an earnings shortfall for 2000 and sought to recognize income from the Blockbuster agreement. In late summer of 2000, Howard asked an EBS finance expert to examine the Blockbuster transaction in order to see if there was any way Enron could derive accelerated earnings from the deal in the fourth quarter of 2000. Howard's goal was to monetize the Blockbuster deal by entering into a structured finance transaction.
82. EBS planned to carry out the monetization by (a) estimating the amount of future revenue that EBS likely would earn over the life of the Blockbuster contract; (b) creating a structured finance entity, in this case a joint venture, and assigning the contract to the joint venture; (c) selling to a third party a portion of its joint venture interest for cash equal to the present value of a portion of the cash expected to be received in the course of the contract, and (d) recording those revenues as if they had been earned not over the life of the contract but at the time of the monetization. All of these aspects of the transaction were to occur simultaneously.
83. During the remainder of 2000, Howard, Krautz, and others worked to accomplish this goal. This structured finance transaction was known at EBS by a code name, "Braveheart." Howard made all of the strategic decisions regarding the transaction and was aware of all material details. Krautz was aware of all material facts related to the deal.
Structure of the Braveheart Transaction
84. In the Braveheart transaction, Enron formed a joint venture, known as EBS Content Systems LLC ("Content Systems LLC") with two investors: nCube, a VOD technology company based in Portland, Oregon, and "Thunderbird," an investment vehicle which was owned by an Enron-controlled investment trust. On the same day that it formed the joint venture, EBS assigned the Blockbuster contract to Content Systems LLC and sold a portion of its interest in the joint venture to an investment structure called Hawaii 125-O, which was created and funded by the Canadian Imperial Bank of Commerce ("CIBC"). Enron recognized the approximately $111 million it received from this transaction as earnings in the fourth quarter of 2000 and the first quarter of 2001. These earnings were recorded on Enron's 2000 10-K and first quarter 2001 10-Q filings with the Securities and Exchange Commission.
Summary of the Fraud
85. The Braveheart transaction and the earnings it generated were fraudulent: nCube was a joint venture in name only; nCube's investment was not at risk; and CIBC's equity stake in the Hawaii 125-0 structure had been guaranteed against loss by Enron. Howard, Krautz and others intentionally created a structure that had no economic substance for the sole purpose of recording $111 million in fictitious earnings for Enron. Enron would not have been able to report the $111 million derived from the transaction as earnings but for the fraud. This amount was material to Enron's reported financial results.
nCube Was A Joint Venture Partner In Name Only
86. The joint venture was a sham because nCube was not expected to participate as a partner in the venture. Howard and the Braveheart transaction team decided not to propose forming a joint venture with Blockbuster because EBS feared losing control over the VOD business. Instead, under Howard's direction, the team elected to form the joint venture with nCube, a small VOD technology company that was one of EBS's vendors. Howard thought this was a good idea because Howard believed nCube would do whatever Enron wanted in the joint venture. In discussions within EBS, Howard stated that nCube would let Enron run the join venture, and Krautz stated that he liked the fact that nCube would not try to dictate strategy.
87. When Howard presented the transaction to nCube, Howard stated that EBS would control the joint venture. According to an nCube executive who participated in a telephone call with Krautz and others to discuss the transaction, an EBS employee stated during the call that EBS would control management of the joint venture, but the transaction documents could not state this, as it would ruin the accounting treatment.
88. After the joint venture was formed, Enron continued to treat nCube like a vendor and not like a true joint venture partner. This fact is evidenced by, among other things, Enron's practice of making all strategic decisions about the joint venture without input from nCube. EBS did not want or seek nCube's participation in the management of the joint venture. According to a senior executive responsible for Enron's VOD business, the joint venture formed with nCube was never a real business, but simply a "box on a piece of paper" designed to allow Enron to report earnings.
89. The planned transaction called for EBS to assign the Blockbuster contract to Content Systems LLC in order to give Content Systems LLC a future revenue stream which it, in turn, could recognize as income. However, under the terms of the Blockbuster contract, EBS was not allowed to assign the contract to a third party not under Enron's control without approval from Blockbuster. EBS initially tried to obtain Blockbuster's consent to a third-party assignment, but Blockbuster refused to consent. After these negotiations failed, EBS lawyers determined that Enron could legally assign the contract to Content Systems LLC without consent from Blockbuster. EBS lawyers reached this conclusion because Krautz had told them that Enron would control Content Systems LLC.
NCube's Investment Was Not At Risk
90. Howard and Krautz knew that nCube's investment was not at risk. To induce nCube to participate in the joint venture, Howard promised nCube in the fall of 2000 that nCube would be "taken out of" the deal early in 2001. At that time, nCube would receive its investment back plus a fixed return in the range of $100,000 to $200,000. Krautz was aware of this arrangement. The guarantee made to nCube clearly violated the requirement that nCube's investment be at risk. This guarantee was intentionally not memorialized or disclosed in the legal documents creating the joint venture.
91. nCube never felt that its investment was at risk because it expected Enron to keep Howard's take-out commitment. Krautz and Howard promised nCube that no matter what happened to the joint venture, nCube would get its money back plus a fixed return in early 2001. Krautz stated to nCube that this guarantee could not be written into the joint venture agreement because it would "blow the accounting treatment."
92. A large number of documents from Enron and nCube confirm the terms of the transaction. These documents include: (a) an October 2000 draft joint venture proposal, which was sent to Howard via e-mail for review and which promised nCube a guaranteed set return on its investment; (b) a November 2000 final joint venture proposal, which was e-mailed to Howard for review, promising nCube a one-to-three month exit with a pre-determined profit; (c) a November 22, 2000 "accounting entries proposal," which was e-mailed to both Howard and Krautz by an EBS accountant, showing nCube exiting the transaction in February 2001 with a $100,000 profit; and (d) a May 2001 memorandum, which was written for and sent to Howard by e-mail, stating that an understanding existed that nCube would be taken out of the deal in 2001 for a fixed profit of $200,000.
93. After Enron formed the joint venture with nCube and Thunderbird, it sold a portion of its interest in the joint venture to the Hawaii 125-O investment trust for $111 million, $53 million in the fourth quarter of 2000, and $58 million in the first quarter of 2001. The $111 million received by Enron from Hawaii 125-O could be reported as earnings rather than debt because the Hawaii 125-O trust was capitalized, in part, with a 3% at-risk equity stake from the Canadian Imperial Bank of Commerce ("CIBC"). CIBC's 3% equity, however, was not at risk.
94. The CIBC investment in Hawaii 125-O was not at risk, because Enron gave CIBC an oral guarantee that CIBC would not lose money on any of its large number of Hawaii125-0 transactions with Enron. On June 21, 2001, a CIBC banker sent an e-mail to colleagues asking about the bank's risk exposure from the Hawaii125-O transactions. Two CIBC bankers responded to the query. One banker stated that Enron's Chief Financial Officer, Andrew Fastow, had "given his strongest possible assurance that the risk won't be realized." The e-mail noted that when the value of one particular asset sold to Hawaii 125-O became impaired, Enron returned the money from the transaction to CIBC. The second banker replied: "Unfortunately, there can be no documented means of guaranteeing the equity or any shortfall or the sale accounting treatment is affected. We have a general understanding with Enron that any equity loss is a very bad thing. They have been told that if we sustain any equity losses, we will no longer do these types of transactions with them. Not many other institutions are willing to take such risks, so it is important to Enron to keep us happy. . . We have done many `trust me' equity transactions over the last 3 years and have sustained no losses to date. If there has been a case where the value of the asset has been in question, Enron has repurchased the asset at par plus our accrued yield." (Emphasis in original).
95. Howard was aware that the CIBC equity was not at risk. Howard presented an executive overview of the Braveheart transaction to EBS's Chief Operating Officer and Chief Executive Officer in April 2001. One portion of Howard's presentation was entitled "CIBC Exit Strategy." It stated that by the end of 2001, Enron would have to replace CIBC with "'true' outside equity, (i.e. without ENE support)."
Blockbuster Termination Risk
96. The Blockbuster contract specified that if EBS failed to sign distribution agreements with four regional Bell operating companies by December 2000, Blockbuster had the right to terminate the agreement. EBS failed to meet this requirement. EBS senior executives, including Howard, the Chief Executive Officer, the Chief Operating Officer and others, discussed the serious risk that Blockbuster would terminate the contract on a daily basis in late 2000. The fact that EBS was in breach of the Blockbuster contract and faced possible termination was not disclosed to nCube, CIBC, Enron's auditors Arthur Andersen or the investing public until March 9, 2001, when Enron and Blockbuster publicly terminated the contract.
97. In order to prevent termination of the contract, EBS negotiated an extension with Blockbuster in December 2000, in which both parties agreed not to terminate the contract before March 2001. One major purpose of extending the agreement was to protect the Braveheart monetization, which would fall through if the contract were cancelled. On December 21, 2000, one day before the Braveheart transaction closed, a lawyer involved in the extension negotiations wrote a memo to the file. In the memo, the lawyer noted that EBS had assumed major potential cost liability in order to get the extension, and in his view EBS would be forced into a "termination scenario" anyway within two months. The lawyer was told by senior executives that the extension was necessary to conclude the Braveheart transaction. The Blockbuster contract eventually terminated on March 9, 2001, before the conclusion of the extension period.
Howard and Krautz Deceived Arthur Andersen
98. Howard and Krautz intentionally misled Andersen about the true character of the Braveheart transaction because they believed that Andersen would not approve of the transaction or allow EBS to record any revenues had Andersen known the truth. Howard and Kurtz did not inform Andersen of facts revealing the true nature of the transaction, and in meetings and conversations with Andersen made false and misleading statements about the transaction.
99. Neither Howard and Krautz, nor anyone else at EBS ever told Andersen that EBS intended to control the joint venture, that nCube was expected to exit the venture early in 2001, that nCube was promised a fixed return for their investment, that the CIBC equity stake was not at risk, that documents had been back-dated, or that there was a significant possibility in late 2000 that Blockbuster and Enron would terminate their relationship.
EBS Treated The Fraud As A Joke
100. In December 2000, the Braveheart team presented a skit and accompanying powerPoint presentation at an EBS Christmas party. Before the presentation, the powerPoint was sent to Howard by e-mail.
101. The Christmas powerPoint presentation joked about numerous fraudulent aspects of the Braveheart transaction and the underlying VOD business. For example, the presentation noted that EBS had been unable to obtain the assignment consent from Blockbuster needed to complete the transaction; that the set top boxes used to deliver movies to the customer had caught on fire during tests; and that the joint venture was only going to last one quarter after which it would have to be unwound. One portion, called "The Grinch that Stole VOD," pictured the Arthur Andersen auditors as Dr. Seuss's "The Grinch," trying to stop the transaction. This section included a piece of Seuss-like rhyme: "One Deal, Two Deal, Red Deal, No Deal. You cannot do it without GAAP. You can't do it because it's crap. You cannot do it for 25. What the hell, let's go for 65." Another portion likened Arthur Andersen to an iceberg that was going to sink the VOD ship.
102. After the party EBS's general counsel directed that all copies of the Christmas powerPoint destroyed. The order was given because the PowerPoint contained incriminating material.
The Fraudulent Earnings Were Material
103. The size of the Braveheart transaction grew rapidly over the course of the fourth quarter of 2000. Enron reported approximately $53 million in earnings from Braveheart in the fourth quarter of 2000 and $58 million in the first quarter of 2001. These amounts were material to the financial results of Enron. These earnings were reported on Enron's fourth quarter 2000 10-K filing and in Enron's first quarter 2001 10-Q filing with the SEC. At Enron's January 2000 analyst conference, Enron's COO projected a $60 million loss for EBS in 2000, the precise loss reported for EBS in Enron's fiscal year 2000 annual report. Enron achieved the targeted figure through the fourth quarter 2000 Project Braveheart transaction.
CLAIMS FOR RELIEF
Violations of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)]
104. Paragraphs 1 through 103 are realleged and incorporated by reference herein.
105. As set forth more fully above, defendants, directly or indirectly, by use of the means or instrumentalities of interstate commerce, or by the use of the mails and of the facilities of a national securities exchange, in connection with the purchase or sale of securities: have employed devices, schemes, or artifices to defraud, have made untrue statements of material facts or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or have engaged in acts, practices, or courses of business which operate or would operate as a fraud or deceit upon any person.
106. By reason of the foregoing, defendants violated Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)], and Rule 10b-5 thereunder [17 C.F.R. § 240.10b-5].
Violations of Section 17(a) of the Securities Act [15 U.S.C. § 77q(a)] (Howard & Krautz)
107. Paragraphs 1 through 106 are realleged and incorporated by reference herein.
108. Defendants, by engaging in the conduct described above, directly or indirectly, in connection with the offer or sale of securities, by the use of the means or instruments of transportation or communication in interstate commerce or by the use of the mails: with scienter, employed devices, schemes, or artifices to defraud, obtained money or property by means of untrue statements of material facts or omissions to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or engaged in acts, practices, or courses of business which operate or would operate as a fraud or deceit upon the purchasers of such securities.
109. By reason of the foregoing, defendants violated Section 17(a) of the Securities Act.
Aiding & Abetting Violations of Section 13(a) of the Exchange Act [15 U.S.C. § 78m(a)] and Rules 12b-20, 13a-1, & 13a-13 thereunder [17 C.F.R. §§ 240.12b-20, 240.13a-1, 240.13a-13]
110. Paragraphs 1 through 109 are realleged and incorporated by reference herein.
111. By engaging in the conduct described above, defendants Howard and Krautz knowingly and substantially caused Enron to file with the Commission a false and misleading report on Enron's 2000 Form 10-K, and a false and misleading first quarter 2001 Form 10-Q.
112. By reason of the foregoing, defendants Howard and Krautz aided and abetted violations by Enron of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.
Aiding & Abetting Violations of Sections 13(b)(2)(A) and 13(b)(2)(B)
113. Paragraphs 1 through 112 are realleged and incorporated by reference herein.
114. By engaging in the conduct described above, defendants Howard and Krautz aided and abetted Enron's failures to make and keep books, records and accounts which, in reasonable detail, accurately and fairly reflected Enron's transactions and dispositions of its assets, in violation of Section 13(b)(2)(A) of the Exchange Act, and further aided and abetted failures to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that Enron's corporate transactions were executed in accordance with management's authorization and in a manner to permit the preparation of financial statements in conformity with generally accepted accounting principles in violation of Section 13(b)(2)(B) of the Exchange Act.
115. By engaging in the conduct described above, defendants Howard and Krautz, directly or indirectly, falsified and caused to be falsified Enron's books, records, and accounts subject to Section 13(b)(2)(A) of the Exchange Act in violation of Rule 13b2-1 thereunder.
116. By reason of the foregoing, Howard and Krautz aided and abetted violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and violated Rule 13b2-1 thereunder.
Violations of Section 13(b)(5) of the Exchange Act [15 U.S.C. § 78m(b)(5)]
117. Paragraphs 1 through 116 are realleged and incorporated by reference herein.
118. By engaging in the conduct described above, defendants Howard and Krautz knowingly circumvented or knowingly failed to implement a system of internal financial controls at Enron.
119. By reason of the foregoing, defendants Howard and Krautz violated Section 13(b)(5) of the Exchange Act.
120. The Commission demands a jury in this matter.
PRAYER FOR RELIEF
WHEREFORE, the Commission respectfully requests that this Court:
A. Grant a Permanent Injunction restraining and enjoining defendants from violating the statutory provisions set forth herein; prohibiting them permanently and unconditionally from acting as officers or directors of any public company; and ordering them to pay disgorgement of illegal gains, and civil penalties;
B. Pursuant to Section 308 of the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 (2002), enter an order providing that the amount of civil penalties be added to and become part of a disgorgement fund for the benefit of the victims of the violations alleged herein; and
C. Grant such other and additional relief as this Court may deem just and proper.