Martha Stewart on the spot

Why is Stewart in trouble?

On Dec. 27 of last year, Stewart suddenly sold $228,000 worth of shares in a pharmaceutical company called ImClone. The Securities and Exchange Commission believes Stewart dumped the 4,000 shares because she had inside information. ImClone, owned by a close friend, Samuel Waksal, had been awaiting FDA approval of its highly touted cancer drug, Erbitux. But on Dec. 28, the FDA announced that the research on Erbitux was flawed, and it would not permit the drug to be marketed. That sent the stock’s value into free fall.

Why was Stewart’s sale suspicious?

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Because of the timing and her inside connection to the Waksal family. On the same day that Stewart sold out of ImClone, Waksal put in an order to dump his stock. So did his father, Jack, and his daughter Aliza, who sold shares worth over $9 million. That triggered an investigation by the SEC. As it looked into the Waksal family’s stock sales, the SEC noticed that Stewart’s broker was Peter Bacanovic of Merrill Lynch. Bacanovic, a former ImClone employee, also served as Aliza Waksal’s broker. Bacanovic called Stewart on Dec. 27 as she was flying to a vacation in Mexico. Her secretary took a message, and Stewart then called him back. Investigators believe that Bacanovic told her that the Waksals were bailing out, and advised her to get out of ImClone—fast.

Is that illegal?

It all depends on what Stewart knew. The laws on insider trading have major gray areas. Very clearly, the laws prohibit corporate officials and those close to them from using their inside knowledge to manipulate the market. In Waksal’s case, the violation is clear: As CEO, he knew of the FDA’s decision before it was announced, and he then attempted to sell his stock to unsuspecting buyers, knowing full well the stock price would crash. (His sale never went through.) Last week, Waksal pleaded guilty to a raft of insider-trading charges. But Stewart will be much harder to prosecute.

How so?

Suppose Bacanovic called Stewart and said, “ImClone is dropping like a rock—I recommend you sell.” In this scenario, Stewart would not have any specific inside knowledge about the Erbitux decision or the Waksal family’s stock dump, and she’d be in the clear. But suppose that Bacanovic told her the Waksal family was selling off its stock, and that Stewart knew ImClone was awaiting the FDA decision. That would border on insider trading. There is some precedent for accusing her of violating SEC laws in that scenario, but the case would be very difficult to prove. A third scenario would be more troublesome for Stewart. Suppose Bacanovic said, “The FDA is rejecting Erbitux, and the Waksals are dumping their stock. Get out now!” That would clearly be insider trading.

Would Stewart go to jail for that?

Not necessarily. Insider trading can be prosecuted as a civil or a criminal violation. In the 1980s, the government did slap criminal charges on big insider traders such as Michael Milken and Ivan Boesky. But their crimes were blatant violations of the law, and prosecutors had testimony from one or more of the conspirators. Most of the time, insider-trading prosecutions are handled as civil complaints. The standard of proof is lower, and the penalties are limited to fines, albeit often substantial ones. Last week, the SEC notified Stewart it would probably pursue civil charges. A decision on criminal charges is pending.

What is Stewart’s version?

Stewart says she knew nothing of the FDA decision or of the Waksals’ sell-off. In November, she says, she gave Bacanovic a “stop-loss” order—instructions to sell ImClone, which had hit a high of $75.45 on Dec. 6, if it dipped below $60. Bacanovic has backed this version of events. Since the stock went below $60 on Dec. 27, the explanation has some plausibility.

Why don’t people believe her?

There are several flaws in Stewart’s story. She can’t document her stop-loss order, and the SEC requires such orders to be put in writing, precisely because of cases like this. An even bigger problem is that Bacanovic’s assistant, Douglas Faneuil, has now contradicted Stewart’s story. Faneuil originally told investigators that Stewart did, in fact, have a stop-loss order. But in October, Faneuil pleaded guilty to lying to prosecutors and said he’d been bribed to back Stewart’s version. Faneuil agreed to serve as a witness for the prosecution.

So it’s his word against hers?

Stewart will also have to explain discrepancies between her story and her telephone records. A congressional committee examined the phone records of all the parties and found evidence of contact between Stewart and Waksal in the days prior to the stock sale. She’s denied talking to Waksal during this time. The records also show one more Dec. 27 call between Bacanovic and Stewart than either have admitted. Asked to explain these discrepancies, Stewart refused to testify before Congress. That prompted the committee to ask the Justice Department to investigate whether Stewart’s story was “false, misleading, and designed to conceal material facts.”

Where does that leave Martha?

With reason to stay up nights. Civil charges are now nearly certain. And the phone records alone open Stewart to criminal charges of perjury. These are felony offenses, and even first-time violators usually go to jail.

Isn’t that harsh?

Federal prosecutors traditionally like to make examples of famous people—especially when it comes to tax fraud and insider trading. By taking a well-known scalp, the government believes, it can intimidate the rest of us into following the rules. Some legal experts, though, say the government would have let Stewart off with a fine if her lawyers had offered a plea bargain early in the case. By now she might be home free. But Stewart is a famously controlling perfectionist; as far back as high school, she said her motto was “I do what I please, and I do it with ease.’’ She may have found it easier to tidy up what actually happened than to admit making a terrible mistake.

A costly scandal

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