Now that title got your attention, didn’t it? ;^)

Selling stocks short receives a bad rap generally because it generates profits from misfortune — i.e., when the stock price goes down — which is counter-intuitive to how most folks believe that one should make money in investments (i.e., holding stocks long-term as they appreciate in value).

The most common method of shorting a stock is to borrow stock, sell it, and then cover the loan of the stock in the market by purchasing the stock later at a lower price. Other approaches to shorting involve buying a put option that holds the right to sell the stock for the next 30 to 60 days at current market prices, writing a call option granting another the right to buy a stock from you for the next 30 to 60 days at current prices, selling a stock future promising to deliver a stock 30 to 60 days in the future, or taking the selling position in a stock swap.

The issues relating to short selling arose in the news again this week as the prosecution in the Lay-Skilling trial played the tape of Jeff Skilling’s infamous “asshole” comment in response to a short-seller’s questions during an April, 2001 analyst conference call. Chronicle business columnist Loren Steffy followed that up with this timely column (related blog post here) in which he correctly points out that — despite such negative aspersions — the practice of short selling provides a valuable market purpose. Indeed, I suspect that Skilling would actually agree with Steffy that short selling is an important part of well-structured securities markets and that his “asshole” comment was not a condemnation of short-selling per se, but rather, a reaction to the short-seller’s improper attempt to profit from creating a false impression about Enron.

Skilling’s comment and Steffy’s column were then followed by this interesting Wall Street Journal op-ed in which Moin A. Yahya condemns the common practice of short-sellers and class action securities fraud plaintiffs’ attorneys banding together to drive the price of a company’s stock down, and then — after profiting from the short sale of the company’s stock — cashing in again on a class action lawsuit against the company. I don’t agree entirely with Professor Yahya’s position in that regard (more on that later), but the professor does provide some highly interesting background into the genesis of the sad case of Jamie Olis:

A few years ago, a Houston-based energy company called Dynegy was experiencing financial difficulties and resorted to some questionable financing activities in what was known as “Project Alpha.” An employee named Ted Beatty learned about the project and informed a friend, who happened to work at a short-selling hedge fund. The fund subsequently took a short position against Dynegy’s stock. Later Mr. Beatty resigned and contributed to a Wall Street Journal article that highlighted the problems with Project Alpha. Much to the hedge fund’s surprise, however, the Dynegy stock price actually rose.

The hedge fund asked Mr. Beatty to help spread the bad news about Project Alpha, and hired a prominent plaintiff’s lawyer to assist him. The fund kept its role secret while Mr. Beatty and the lawyer kept working to lower Dynegy’s stock price. Mr. Beatty contacted various media outlets, government agencies, a credit rating agency and the local SEC office. The SEC announced an informal inquiry, which finally lowered the stock price. The lawyer’s firm launched a shareholder suit against Dynegy for its fraudulent practices. The hedge fund netted around $150 million from the fall in the price of Dynegy stock.

Project Alpha, of course, is the series of transactions upon which Olis’ conviction and over-the-top 24-year prison sentence are based.

As to Professor Yahya’s condemnation of the practice of “dumping and suing,” Larry Ribstein believes that he has missed the proper analytical framework for addressing the perceived abuses of the practice:

If a plaintiff or his lawyer (with the plaintiffís permission, so no misappropriation) is short-selling based on the true information that a suit is forthcoming I donít see how this is illegal under current law ñ itís not fraud without a duty to disclose, and itís probably not illegal insider trading or manipulation.

Yahyaís WSJ oped persists in his blanket claim of illegality despite this fairly elementary principle of securities law. As a result, he allows his polemic against the practice to obscure some real, and more important, issues.

To begin with, there is actually something to be said for using the markets to compensate people who bring in new information, such as the information underlying a lawsuit. Yahya calls this double-compensating class action lawyers. But the question is whether the fee the lawyer receives provides a socially optimal incentive to sue.

Now I can already hear the howls: how could I possibly be suggesting that securities class action lawyers are under-compensated? Well, Iím not saying that. Iím only positing the correct analytical approach. Assuming over-compensation is an incorrect way to analyze this issue. . . .

[C]onsider that a rule broadly characterizing undisclosed material information (in this case, about the intent to sue) as fraud could seriously extend the reach of the fraud laws. We have to remember that a rule intended to “catch” the people we don’t like could end up “catching” those we do.

I know that trial lawyers aren’t cool in some circles. But let’s make sure the weapons we fashion against them don’t circle back on the rest of us.

Read Professor Ribstein’s entire piece. Although Professor Yahya’s identification of the dumping and suing practice is interesting, Professor Ribstein is correct that more regulation is not the answer to controlling the perceived abuses that may arise from the practice.

Meanwhile, Jamie Olis remains in prison awaiting re-sentencing, a pawn of dynamic forces in the securities markets and the criminal justice system that are far stronger than any man could — or should ever have to — defend himself against.