updated 3/2/2006 7:52:30 PM ET 2006-03-03T00:52:30

Former Enron Corp. Chief Executive Jeffrey Skilling told other top executives “they’re on to us,” when a small analyst firm produced a research note critical of the company’s sales to partnerships run by then-Chief Financial Officer Andrew Fastow, a former top executive testified in a bombshell revelation Thursday.

Minutes before that, Skilling said at the May 2001 meeting — attended by company founder Kenneth Lay — that he had “brought Andy here” to talk about those partnerships, called LJM1 and LJM2.

“Fastow said, ’LJM is a good deal for me,”’ Kevin Hannon, then chief operating officer of the company’s flailing broadband unit, told jurors in the fraud and conspiracy trial of Lay and Skilling.

“As I remember, (Fastow’s comment) was met by stunned silence,” Hannon said.

“Did Mr. Skilling say anything?” prosecutor Cliff Stricklin asked.

“Yes. He said, ’They’re on to us,”’ Hannon said. “It seemed to indicate the investment community was beginning to understand how Enron made money.”

Hannon’s statements — in the last 10 minutes of testimony Thursday — were a potentially devastating blow to the defendants. Their lawyers have maintained that Lay and Skilling did nothing wrong and there was no fraud at Enron besides the theft of money by Fastow and two other former executives.

But Hannon’s inside view of the company’s executive policy meeting appeared to directly challenge the defendants’ insistence that the LJM partnerships were proper and received appropriate approvals from lawyers and accountants as well as Enron’s board.

Prosecutors contend the partnerships were one of a slew of accounting tricks used to prop up a wobbly company that Lay and Skilling touted publicly as healthy before it spiraled into bankruptcy proceedings in December 2001.

Hannon’s prosecution testimony was to continue Monday, followed by cross examination. Trial is not in session on Fridays.

His revelation set the stage for testimony next week from Fastow. Lay has labeled him as a crook who skimmed millions of dollars from the company until his ouster in October 2001, one day after the founder publicly defended his honesty and ethics.

Fastow is slated to succeed Hannon in the witness chair in a much-anticipated confrontation with his former bosses. He pleaded guilty in January 2004 to two counts of conspiracy for orchestrating schemes to manipulate Enron’s reported earnings. He has already agreed to serve the maximum 10-year sentence for the crimes, with potentially a year and a half off for good behavior.

Fastow pocketed about $60 million in management fees and other income from running the partnerships, which he created exclusively to buy Enron assets and conduct other deals with his main employer.

Lay and Skilling aren’t alleged to have known how much Fastow pocketed. But prosecutors contend they knew the LJM partnerships were among tools used to manipulate earnings so the two men could present a falsely rosy picture of Enron’s health to investors.

Hannon has admitted to conspiracy for helping promote the weak broadband unit as healthy.

Fastow’s appearance would mark his first public statements about his admitted crimes at Enron. He also is the first government witness who is not testifying in the hopes of receiving more lenient punishment, a reason the defense has used to undermine the testimony of his predecessors.

Another witness who finished testifying Thursday set the stage for Fastow’s appearance.

David Delainey, a former trading and retail energy executive, told jurors he worried in 2000 whether it was proper for off-the-books financial structures backed by company stock to serve as insurance against losses, but Fastow’s endorsement of them convinced him to go along with the plan.

The structures, known as Raptors, were “a plot of money we used to manipulate our income statement,” Delainey said in his third and final day of testimony.

“I was definitely concerned about the Enron stock part of it,” said Delainey, who headed the highly profitable Enron wholesale trading unit, Enron North America, before shifting in 2001 to run the struggling retail business segment, Enron Energy Services. “I certainly relied on what I heard from Mr. Fastow at the time.”

Delainey testified earlier that he first learned of the Raptors in 2000 and that their architect, then-Enron Treasurer Ben Glisan, offered the structures as a way for Enron North America to avoid booking losses from poor investments.

But Delainey said he found it “odd” because the structures’ use of Enron stock for capital meant the company was using its own shares in a way that could influence its income statement.

He asked Skilling about it, and Skilling “said it had been approved,” Delainey said.

Allegations against Skilling include that he knew the Raptors were wrongly treated as independent of Enron and that they were used to avoid public disclosure of decreases in asset values.

Glisan pleaded guilty in September 2003 to conspiracy in part for developing the Raptors to help manipulate Enron’s books. He is serving a five-year prison sentence and is slated to testify against Lay and Skilling.

Skilling faces 31 counts of fraud, conspiracy, insider trading and lying to auditors, while Lay faces seven counts of fraud and conspiracy. If convicted, both could serve decades in prison. Only Skilling faces allegations of improper stock sales.

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