Purpose of Project Braveheart
Project Braveheart was a joint venture between Enron Broadband Services and Blockbuster. The goal was to use Blockbuster’s vast entertainment library to run over the Enron network – in other words, video on demand.
The Project Braveheart Players
Kevin Howard, CFO of Enron Broadband Services, and a young accountant named Michael Krautz were indicted for a mix of crimes along with the EBS technology defendants, Rex Shelby, Joe Hirko, and Scott Yeager, Ken Rice and Kevin Hannon. Kevin Howard and Michael Krautz were the only two indicted for crimes involving Braveheart.
The Alleged Criminality of Project Braveheart
Anyone familiar with the corporate prosecutions at Enron will recognize the allegation here: prosecutors allege that Project Braveheart was a conspiracy to manipulate accounting rules so that earnings targets could be met.
The allegations of wrong-doing center on an attempt to monetize future earnings from EBS’s deal with Blockbuster. EBS created partnerships with a Portland vendor, nCube. nCube and Enron created a project called Thunderbird, which was partially funded with Enron-controlled investment, Whitewing. Each of these entities contributed the required 3% of outside equity to the partnership, the minimum to count it as a separate entity for accounting purposes.
They sold the venture to another investment partnership called Hawaii 125-0, which EBS had created with the Canadian Imperial Bank of Commerce and then booked the $111 million as revenue.
Prosecutors allege that the sale was phony because the outside equity was not adequate and it was not a “true sale,” evoking a shade of the Nigerian Barges with their “what is a sale” questions and the allegation that EBS only partnered with nCube for the purpose of meeting its earnings target for the year 2000. Prosecutors also used that old chestnut, the “secret side deal” that made Andy Fastow in Corporate so famous. According to Kevin Howard’s plea agreement, through discussions with Howard and others at EBS, nCube understood that it would not suffer financially in any way from participating in Project Braveheart and that EBS was going to arrange for the company to be bought out of the joint venture by a third party the next quarter.
It must be noted that Kevin Howard’s plea agreement is garbage. He did nothing wrong at all; he eventually accepted a plea agreement, like so many others, because he was tired of the emotional cost to himself and his family. There is nobody at EBS who believes that Kevin Howard was a liar or in fact dishonest in any way. I only use the plea agreement to point out the prosecution’s allegations, not the facts in evidence.
What Does The Indictment Say?
Vis a vis Braveheart:
Defendants HOWARD, KRAUTZ and others also intentionally deceived Arthur Andersen accountants working on the transaction by failing to disclose, among other things, that the Braveheart transaction deliberately had been structured in a way that violated applicable accounting requirements. As HOWARD and KRAUTZ knew, had all of the facts about the transaction been disclosed, Enron would not have been able to report any of the $111 million as revenue.
Impact of the Braveheart Transaction
28. In the fourth quarter of 2000, $53 million of EBS’s reported $63 million in revenue came from Braveheart, while in the first quarter of 2001, $58 million of EBS’s $85 million in reported revenue was from the transaction. On January 22, 2001, Enron’s Chief Operating Officer announced to equity analysts on a conference call that EBS had met its $60 million loss target. Absent the fraudulent Braveheart revenues, EBS would have missed its publicly stated target for the year 2000 by more than $50 million. Similarly, in the first quarter of 2001, EBS would have missed its quarterly target but for the revenues from the fraudulent Braveheart transaction. Enron reported the revenues from the Braveheart transaction on its publicly filed SEC form 10-K for 2000 and SEC form 10-Q for the first quarter of 2001.
29. The January 25, 2001 Analyst Conference 29. Between approximately October 2000 and January 22, 2001, defendants RICE and HANNON were repeatedly informed that: EBS was performing very poorly; EBS had made little commercial progress during 2000; EBS’s network operations should be shut down or sold; and EBS had an unsupportable cost structure. This information was provided by senior executives, independent business consultants, and in weekly management summaries setting forth EBS’s projected losses. On January 22, 2001, RICE and HANNON were informed that every business unit at EBS was losing money and that EBS currently estimated that it would lose more than $149 million in the first quarter of 2001.
30. In December 2000, defendants RICE and HANNON also became aware that Blockbuster was threatening to terminate the EBS-Blockbuster VOD agreement because, among other things, EBS had failed to meet its contractual commitment to sign distribution agreements with each regional Bell operating company by December 2000. In order to prevent termination, which would threaten the Braveheart transaction, EBS negotiated an extension with Blockbuster in which both parties agreed not to terminate the agreement before March 2001. The agreement was subsequently terminated in March 2001.
31. In January 2000, defendants RICE and HANNON held a series of meetings to plan the EBS presentation for Enron’s upcoming annual equity analyst conference, scheduled for January 25, 2001. During these meetings, RICE and HANNON, among other things, reviewed estimates of EBS’s value. During one meeting, RICE and HANNON reviewed a model showing the value of EBS’s content distribution business as $8 billion, a sharp decline from the $18 billion estimate presented at the 2000 analyst conference. After RICE stated that he would not allow EBS to present a number lower than the prior year, the number was inflated to $21 billion.
32. On January 25, 2001, defendants RICE and HANNON made a presentation about EBS at Enron’s annual equity analyst conference. In the EBS presentation, RICE stated, among other things, that EBS’s strategy was right on target; EBS’s content delivery business had an outstanding year; Blockbuster was EBS’s “anchor tenant” with a 20-year deal; EBS had a commercially viable and scalable broadband delivery platform; the BOS network control software was up and running and controlling Enron’s network; EBS was ahead of where it expected to be in January 2000; and EBS, which Enron claimed was worth an estimated $30 billion in January 2000, was now, after deducting costs, worth $36 billion, with $21 billion of that figure derived from content services. These statements and others were false and misleading. RICE and HANNON did not disclose that EBS was performing worse than expected, that every business unit at EBS but one was losing more money than expected, that EBS did not have a cost effective or scalable broadband delivery platform, that the BOS network control software was still under development, that the Blockbuster deal was in danger of cancellation and had been extended only through March 2001, or that, even though EBS had yet to receive any recurring revenue from the Blockbuster deal, it already had sold the majority of the future revenue from the Blockbuster contract through the Braveheart transaction. RICE also stated that EBS would lose $65 million in 2001, even though he had been provided three days earlier with EBS’s own internal estimate of far greater losses.
Sorting Out The Financials
The indictment mentions a 2001 conference, but I’d like to look at an excerpt from the transcript of the 2000 conference. This is from the end of the regular presentation and before the BOS presentation.
Jeff Skilling says EBS will burn three million dollars and the metrics have nothing to do with movies at all.
But the cash flow model assumes 2008 revenues of $11 billion to $12 billion
Note that this is eight years in the future – clearly a long term business plan.
There is a burn rate associated with this business. It’s similar to the burn rate that we had in the retail business. Discount that back and that’s about a $3 billion deduct from us, so….
Skilling is saying clearly that the retail business took years to develop and Enron lost a lot of money getting it going. He is comparing EBS to the Retail business, so this is another example of it taking time and money to get to EBS to become a money making business. The government kept saying the business never made money like that is a crime. It was stated it would not make money for a while and it would take time and money. Skilling said the burn rate is 3 billion– not just the $60 million loss in 2000 that is predicted but $3 billion. This is a lot of money and the market was told this in the financial section of the presentation. How can the entire false earning allegation of the Blockbuster/Braveheart part of the case matter at all?
As stated previously, Enron Broadband Services was a tiny technology start-up inside a vast intermediation company. Practically speaking, EBS did not matter to Enron’s bottom line. Enron wasn’t biting its nails praying that tiny little EBS would turn a profit or meet its goal of burning $60 million.
I think the government picking this out is like looking at a graph of a stock that goes up over a very long period of time, but inside that period of time you have day to day fluctuations. The government is saying that this loss is somehow akin to Broadband being worthless. It doesn’t compute.
Furthermore, don’t take my word for it. Take Ken Rice’s! On the stand, Rice said something to the effect that whatever happened with Braveheart was utterly insignificant to Enron and Enron’s financials. It was below the level of notice in the overall scheme of things.
Michael Krautz testified that it was not a catastrophe if the targets were not met:
Michael Krautz: EBS’s earnings targets were — were significant from the standpoint of letting the people at corporate know how they were doing in accordance to the Enron overall target and specifically letting them know if they needed to adjust targets with different divisions to meet the overall earnings targets, so, to keep corporate abreast of how it was going.
Barry Pollack: What was your experience throughout your time at Enron about what would happen, if anything, if a subsidiary didn’t meet that subsidiary’s earnings targets?
Michael Krautz: It was — I’d say it happened several times. And there was a reallocation procedure, which I believe was called “Overview,” where corporate would find out from the different divisions how different divisions were performing, compare that to the overall target, and, if one subsidiary wasn’t meeting its target, they would adjust the allocations of subsidiaries that were doing better so that the overall corporate number could be met.
So, no big whoop. Furthermore, in a sidebar with Judge Gilmore, Pollack points out that Andy Fastow pressured Krautz to change his accounting to better suit Enron Corporation and Krautz was principled enough to refuse:
THE COURT: When did this transaction start? [The Judge is referring to another transaction, not Braveheart.]
MR. POLLACK: This is the transaction June 30th, 2000, during the middle of the conspiracy. It is a transaction the Government has said was the sole reason that EBS made its earnings targets for the second quarter. What is significant about Mr. Krautz’ testimony is that Mr. Fastow asked him to change his view of the accounting to allow this transaction to go through and specifically told him that if he didn’t agree to do so EBS would not make its earnings targets and Mr. Krautz refused to change his view of the accounting.
Two Good Reasons The Allegation Makes No Sense
1. nCube was owned by Larry Ellison, the CEO of Oracle. There has never been a whisper of controversy about Ellison’s ethical makeup. For him to involve himself in a scheme to assist a tiny Enron subsidiary to make its earning targets is to strain credibility.
2. There was no reason to lie to make earnings targets. As Michael Krautz and others testified, it was not a big deal to miss earnings targets. And Krautz had no reason to lie at all – he had no stock. He made a tiny bonus compared to other people (a five figure bonus, not seven!) He literally could not benefit in any way by lying to Arthur Andersen, Enron Corporation, or Enron stakeholders.
Project Braveheart was one of many good ideas to come from Enron. Imagine today what it would have been like in 2000 to have movies on your computer, on your phone. EBS was trying to make it happen, and it is a shame that the company collapsed before they could succeed.