At the time it was called 'the most widespread security incident in the history of the Web'. In 1999, hackers revealed a security flaw in Hotmail that permitted anybody to log in to any Hotmail account using the password 'eh'. Later development saw the service tied with Microsoft's web authentication scheme, Microsoft Passport (now Microsoft account), and integration with Microsoft's instant messaging and social networking programs, MSN Messenger and MSN Spaces (later Windows Live Messenger and Windows Live Spaces, respectively). In 2002 Hotmail still ran its infrastructure on UNIX servers, with only the front-end converted to Windows 2000. In June 2001, Microsoft claimed this had been completed a few days later they retracted the statement and admitted that the DNS functions of the Hotmail system were still reliant on FreeBSD. A project was started to move Hotmail to Windows 2000. Hotmail originally ran on a mixture of FreeBSD and Solaris operating systems. Hotmail quickly gained in popularity as it was localized for different markets around the globe, and became the world's largest webmail service with more than 30 million active members reported by February 1999.

The sale had been preceded by a major incident in 1997 where all email was lost for 25 % of mailboxes. Hotmail was sold to Microsoft in December 1997 for a reported $400 million, and it joined the MSN group of services. Hotmail initially ran under Solaris for mail services and Apache on FreeBSD for web services, before being partly converted to Microsoft products, using Windows Services for UNIX in the migration path. By December 1997, it reported more than 8.5 million subscribers.

Hotmail was initially backed by venture capital firm Draper Fisher Jurvetson. The name 'Hotmail' was chosen out of many possibilities ending in '-mail' as it included the letters HTML, the markup language used to create web pages (to emphasize this, the original type casing was 'HoTMaiL'). It was commercially launched on July 4, 1996, symbolizing 'freedom' from ISP-based email and the ability to access a user's inbox from anywhere in the world.

Hotmail service was founded by Sabeer Bhatia and Jack Smith, and was one of the first webmail services on the Internet along with Four11's RocketMail (later Yahoo! Mail).

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