Skilling one of the 'vultures'
A key defense theme in the Enron trial has been greedy shortsellers. Never mind that one of the defendants made $15 million shorting an energy company.

FORTUNE (HOUSTON) - From the start of opening arguments, a key defense theme in the Enron trial has been that greedy short-sellers played a big part in bringing down the company, by conspiring with the media and triggering a fatal "run on the bank." Mike Ramsey, Ken Lay's lead defense attorney, for example, called shorts "vultures" who "are trying to kill a company so that they will make money."

So it seems a little ironic -- to put it gently -- that among those who profited hugely from the sharp decline in energy-company stocks in late 2001 was a short-seller named Jeffrey Skilling -- the same Skilling who is expected to take the stand soon in his own defense.

Former Enron CEO Jeffrey Skilling arriving at the courthouse in Houston Thursday.
Former Enron CEO Jeffrey Skilling arriving at the courthouse in Houston Thursday.
Find out who you might have seen at the Enron trial, how they got involved, and what they're doing now.
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Just ten days after quitting as CEO of Enron on August 14, 2001, Skilling shorted 400,000 shares of AES (Research), an Arlington, Virginia-based energy giant with power plants, pipelines and 30,000 employees around the globe; the stock closed that day at $35.32. On September 6, with AES still at about $30, Skilling doubled his AES short position to 800,000 shares.

This was a huge, highly risky bet -- every dollar AES rose would have cost him $800,000; if the company's shares had doubled, he would have been out about $26 million.

Instead, the price headed south. Skilling held onto his short position through late September 2001, when AES bottomed out at just under $12 a share after announcing that it would miss its profit numbers. Presumably Skilling expected the price to go even lower -- or perhaps even imagined that AES might go bankrupt. He finally "covered" the short position on November 5, when AES closed at $13.78, raking in a profit of more than $15 million in less than three months.

Skilling's short investment in AES is not news. It was first revealed in a January 2002 story by Wall Street Journal reporter Ken Brown. But Skilling's criminal prosecution has exposed some additional details about the deal, and it has gone virtually unmentioned in the context of his ongoing trial.

That is certain to change when the former Enron CEO takes the stand. Prosecutors have said in court that they intend to question him during cross-examination about his trades in AES.

If Enron was 'in great shape,' why was AES a short?

In particular, they will likely suggest that the huge AES bet (which Skilling says is the only short investment he has ever made) is evidence he was privately worried that Enron and other energy-company stocks were headed for a fall. This would be inconsistent with his public confidence that Enron was "in great shape" and that its stock was undervalued.

Specifically, prosecutors may suggest that Skilling's AES short served as a hedge for his big investment in Enron (at the time more than a million shares), offering protection from revelations about the company's problems. So why didn't he just unload all his Enron shares? There was no legal restriction on him doing so, but selling such a big position so soon after leaving the company might have invited scrutiny from regulators, investors and the press.

Prosecutors will also surely cross-examine Skilling about his moves to cut his Enron holdings. On September 17, he sold 500,000 shares of Enron. In a sworn deposition that December, right after Enron declared bankruptcy, the SEC questioned whether he had been motivated by inside information.

But Skilling insisted that the only reason he'd sold was concern that the market would tank in the aftermath of the September 11 attacks. Oops -- criminal prosecutors later discovered a tape-recorded call where Skilling had placed an order to sell 200,000 Enron shares on September 6; that sale had been blocked by his broker, Charles Schwab, requesting additional paperwork.

Although Skilling regularly extolled the virtues of the free market in speeches, he made no secret of his personal loathing for short-sellers -- at least those who were shorting his company. On a spring 2001 investor conference call, he famously responded to the persistent questioning of one short seller -- Richard Grubman of Highfields Capital -- by calling him an "asshole."

"I mean, this guy," Skilling later told the SEC, in trying to explain his choice of words, "....he was a short guy. He was trying to drive down the price."

In his SEC testimony, Skilling said he shorted AES because he believed its international projects were in even worse shape than Enron's. "So I figured when the market came down these guys would come down even worse."

'They are never going to get paid for that stuff... it's not for real'

Indeed, as he described it to the SEC, Skilling's reasons for shorting AES were -- dare we say it -- strikingly similar to the reasons other investors had for shorting Enron. AES' continued earnings growth, in the face of market problems, seemed inexplicable; it faced regulatory problems in major markets; and it had already booked revenues whose eventual collection was in serious doubt.

Conversations with Enron's "guys," Skilling said, had convinced him that "they are never going to get paid for that stuff.....it's not for real."

"Here was a guy trying to profit from shorting a stock where he believed the fundamentals were worsening," says Jim Chanos, whose hedge fund, Kynikos Associates, made millions shorting Enron in 2001. "There's a delicious irony there."

While it is Lay's attorneys who have wielded the harshest rhetoric about short-sellers, it is a major theme of the joint defense that Enron was a healthy company brought down by predatory shorts collaborating with the media, whose unfair negative stories triggered a "run on the bank" that drove Enron into bankruptcy.

Daniel Petrocelli, Skilling's lead lawyer, has consistently sought to discredit criticism of Enron by suggesting it originated with short-sellers. In cross-examining one prosecution witness, Mark Holscher, another Skilling lawyer, suggested that the defendant had branded a critical investing report about Enron, published by a newsletter called Off Wall Street, "a pile of short-seller crap."

Asked whether Skilling's AES trades undermined the defense's vilification of shorts, Petrocelli walked a considerably finer line than has been evident in court. "There is nothing wrong with short sellers," he told FORTUNE in an e-mail. "There is something wrong when they collude to drive down your company's stock."

Petrocelli also denied that the defense is saying "that short sellers brought Enron down," but merely is arguing "they contributed to a severe downward pressure on the stock."

The argument that shorts can help destroy an otherwise healthy company may appeal to a jury-- many people have an instinctive dislike for shortsellers, who are, after all, profiting from other people's misery. But in truth, it is a dubious proposition.

As Owen Lamont, an economist at Yale who studies shortselling, notes: "I cannot think of a single example of a truly non-fraudulent company that was brought down by shortsellers." Speaking of Enron, Lamont adds: "The shortsellers didn't cause the accounting problems. The accounting problems caused the shortsellers."

Indeed, if an accounting scandal, heavy short interest, and a need for access to the capital markets were enough to destroy an otherwise sound company, both AIG and Fannie Mae would be bankrupt too.

If short interest really could drive a company into the ground, it also would have been AES, not Enron, that ended up in bankruptcy. During each of the first nine months of 2001, short interest in AES, as measured by a percentage of the stock's total float, was actually higher than it was in Enron.

That means Skilling was just one of many greedy "vultures."

Additional reporting by Doris Burke and Joan Levinstein Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.