The Case of Martha Stewart, Research Paper Example

America, and indeed the entire Western world, has a long history of financial scandals that play themselves out in the popular media, some to be remembered, others to be forgotten except to students of history. To read a list of the more recent ones is to take a mental trip down a kind of Memory Lane of vaguely remembered names, headlines, and news stories. In the past ten years alone, the names Enron, Bernie Madoff, Frank Quattrone, Global Crossing, Halliburton, Tyco, and WorldCom became, if only briefly, household names, or at least water-cooler ones. But with the possible exception of Madoff or Quattrone, none of these scandals had star power. Madoff was unknown to the public before his own scandal hit, and, now serving a life sentence in federal prison, will be unknown to the generation now growing up. Quattrone, effectively exonerated and very rich, has resumed his business success off the public’s radar. But the name Martha Stewart is still very familiar to people around the world, even as they continue to misunderstand the most basic of facts about her case. Millions knew her name even before her own tour of the tabloids began. Today her star power remains undiminished and her reputation intact if not bolstered by reports of her resilient character while in prison and after.

This paper is about Stewart’s own very interesting brush with scandal, probably the most dramatic financial cause célèbre since the Whitewater affair ten years earlier ensnared then-U.S. President Bill Clinton and his wife Hillary, currently the U.S. Secretary of State. I will first describe the background leading up to Stewart’s trial, and its aftermath. I will then discuss the case’s ethical and legal implications, and the related matter of the ethics of insider trading.

Background

ImClone Systems, Inc., a biotech company, had been developing a drug for the treatment of colon cancer for years. Millions had been spent on it, and it had once nearly bankrupted the company. The drug, Erbitux, needed to be approved by the Food and Drug Administration (FDA) before it could be prescribed to patients. In October of 2001, following the standard battery of safety testing,[1] ImClone submitted an application to the FDA for approval. Hopes had been high for the drug, but by December 14, 2001, ImClone’s stock price was $70 per share, five dollars off its recent high. The ruling for or against approval was expected by the end of that month. On December 15, the price continued falling, and short-selling of the stock[2] reached $77 million.[3] The FDA approval process is not fully leak-proof, and word had gotten out that there might be problems with ImClone’s testing process. On December 27, the stock opened at $63.49 and closed at $58.30. Later that day, Bloomberg News reported the price falling sharply on rumors (which turned out to be true) that the FDA approval of Erbitux was in doubt.

Martha Stewart owned 3,928 shares of ImClone stock. She also knew the company’s owner, Sam Waksal, who at one time dated Stewart’s daughter, Alexis. On December 26, Waksal learned what the stock market had been guessing since at least the middle of the month: that the FDA was going to reject ImClone’s application. He immediately tried to sell his own shares, and, blocked from doing so, transferred as many shares as he could to his daughter Aliza, who immediately sold $2.5 million worth. Altogether the Waksal family sold about 150,000 shares that day.[4] On December 27, 7.7 million shares of ImClone were traded, five times the previous day’s volume. En route to Mexico by plane on the 27th, Martha Stewart sold her own 3,928 shares after a short phone-call to the office of her broker, Peter Bacanovic. He was not available and Stewart spoke to his assistant, Douglas Faneuil, who ordered the sale. Afterwards, Stewart left a phone message for Waksal telling him that she wanted to know what was going on with ImClone’s stock. Reported out of context (as it always was in the popular press) the timing of the sale looked suspicious. Given the personal relationship between Stewart, Sam Waksal, and Alexis Stewart, it looked like a potential case of insider trading, and indeed Waksal later went to prison in part for his own transactions that day that were found to be illegal.

Martha Stewart was questioned by federal officials. She claimed that there had been a stop-loss order for her shares to be sold if they fell to $60. Her shares sold for $58.43. Mr. Faneuil, the assistant who handled Stewart’s sell order, initially supported Stewart’s story of the stop-loss order. But he changed his tune when the government offered him immunity from prosecution for the crime of insider trading and obstruction of justice. He now claimed that his boss, Mr. Bacanovic, ordered him to tell Stewart that the Waksal family was selling its stock.

Ordinarily, acting on the advice of your broker, regardless of the broker’s source or reasoning, would not get a ordinary stock trading citizen into trouble with the law, any more than overhearing and acting upon a stock tip overhead in a restaurant would. However, thirty years before, Stewart had herself been a stockbroker. Seen in that light, using insider trading might, at least theoretically, been a violation of the law in her case. However, it could have only been a violation of the law if in fact Stewart acted on inside knowledge while employed as an executive or board member or as a stockbroker herself actively handling ImClone’s stock. In any event, no such charge was brought against her in the Justice Department’s indictment, the evidence, such as it was, being insufficient. Instead, Stewart was charged with nine counts of making false statements centered on the matter of the stop-loss order. One charge, that of securities fraud, was based on the accusation that Stewart had denied her guilt and invoked her 5th Amendment right against self-incrimination in order to protect the stock price of her own company, Martha Stewart Living Omnimedia (MSLO). That charge, Kafkaesque in its implications and drawing increasing attention from commentators, was later thrown out by the trial judge.

The only physically evidence presented was a log-entry consisting of “@60” that Bacanovic had allegedly added to substantiate the $60 stop-loss story. The question was whether it had been added later as part of a conspiracy to cover up the lack of an actual stop-loss order. Larry Stewart (no relation to Martha Stewart), the Secret Service’s lab director, testified that the ink used in the entry was “scientifically distinguishable” from the other ink used on the page, indicating (but not proving) that the notation could have been made later and so legitimately placing it under the shadow of suspicion.[5]

There was also an altered computer log-entry. Ann Armstrong, Mrs. Stewart’s assistant, testified that she initially changed, at Mrs. Stewart’s behest, a company computer’s log entry dealing with the stock deal, but that Stewart quickly told her to change it back, and never asked her to lie for her about it. (Mrs. Stewart was prevented from testifying by her own attorney.)

Mrs. Stewart was found guilty of four of the remaining counts. Interviews with jurors afterward showed that they appear not to have fully understood the issue of the allegedly “insider” stock trade vs. the matter of making false statements. Peter Bacanovic, Stewart’s stockbroker, was acquitted of the charge of falsifying his company’s log with the “@60” notation, yet Chappell Hartridge, a member of the four-man, eight-woman jury, was quoted as saying after the trial that the jury felt Stewart’s background as a stockbroker meant “she should have known her moves were illegal,” adding “Maybe it’s a verdict for the little guys who have lost money in the market. It’s a message to bigwigs in corporations that they have to abide by the law.”[6] To understand the implications of that statement, it must be known that the trial judge, Miriam Goldman Cedarbaum, prohibited the defense team from informing the jury that it was perfectly legal for Martha Stewart to sell on her broker’s advice, regardless what Mr. Faneuil may have said or why. (In 2006, under the lower standards of proof required in civil law, Stewart settled a suit brought against her by the Securities and Exchange Commission (SEC) for insider trading. She paid various fines and agreed to a five-year ban on her serving in any executive capacity involving the preparation of financial statements of any publicly held company.)

Aftermath

Upon her indictment and before her trial, Stewart resigned her executive positions at Martha Stewart Living Omnimedia but continued to oversee new projects. Her appeal for a new trial, based on the false statements by juror Chappell Hartridge on his jury-summons form, was denied on the grounds that Hartridge had simply erred, or misunderstood how his own past related to the jury form questions, and that his background did not necessarily show pre-trial prejudice against Stewart. Stewart was sentenced to five months in a federal prison and ordered to pay $30,000 as well as other financial penalties. She served her time in West Virginia. She was also sentenced to two years’ supervised release, and five months of home detention with electronic monitoring (an ankle bracelet). Thereafter the effects of the trial and prison time were minor: she was briefly prevented from traveling to Canada to attend a pumpkin festival, and later prevented from entering Great Britain for a fashion show because of her status as an ex-felon. Neither trips involved financial matters relating to her company.

During the pre-trial and trial phase, Stewart’s company, Martha Stewart Living Omnimedia, laid off several hundred of its employees, and its stock value fell by 23% after the verdict was announced, and at its low point had lost half its value. Today, Martha Stewart’s financial worth is variously reported as being between $650 million and $2 billion. She has interests in publishing, broadcasting, and merchandising, with her own branded magazine Martha Stewart Living. She controls about half of the stock of her company (MSLO). It is fair to say that today no meaningful social or professional stigma attaches to Stewart.

This is quite a turnabout from 2004, when trademark attorney Jim Astrachan, writing in a paper called Martha’s Greek Tragedy, actually speculated that the U.S. Patent and Trade Mark Office might rescind the Martha Stewart trademark. The grounds for this line of thought was that registration of a trademark will be rejected if it has become associated with “scandal, immoral purpose, or degradation of an identifiable group.” As evidence of Stewart’s slide towards these restrictions, he cited the cancellation of the Martha Stewart Living TV program in 2004 after her conviction of the charges cited above. “The original Trademark Act provided little guidance to the meaning of these words: Giving offense to the conscience, exciting reprobation; calling out condemnation; disgraceful to reputation; shocking to the sense of truth, decency or propriety. It is not a stretch to believe that these definitions from the original Trademark Act could be applied by some to Martha Stewart.”[7] However, Mr. Astrachan’s fears were not realized. Martha Stuart Living returned in 2005 with a new title, Martha (not instigated by a trademark lawsuit) and ran until May of 2012.

Contrary to such expectations, it is hard to avoid the impression that most members of the public never really took the charges seriously as law in the first place, if only because they were not familiar with the basics of the case at all, as reflected in the fact that so many news stories spun the story against her (principally by not mentioning the almost month-long slide in ImClone’s stock price before Stewart sold her own shares) for so long and went unrebuked for doing so. Instead, people appear to have used the occasion to sanctimoniously gloat over the spectacle of a rich media mogul being brought down for “insider trading” and “lying” — but beyond that, no hard feelings. Stewart met the challenge of prison head-on and by all accounts did well there. She did not appear to weaken, opting to serve her time immediately rather than wait for the outcome of an appeal. In so doing she defeated the public’s earlier schadenfreude,[8] thus earning Stewart the right to resume her life and business success, which she has done.

Ethics of the Case

From the outset, there are two sides to consider: the ethics of the prosecution and the ethics of Martha Stewart. The case itself began with a leak from the House Energy and Commerce committee, led by chairman Louisiana Congressman Billy Tauzin, with Pennsylvania Congressman Jim Greenwood in charge of the Oversight and Investigations Subcommittee heading the ImClone investigation. The leak went to Associated Press reporter Theresa Agovino, who, on June 7, 2002, publically reported that “There are allegations that certain people profited handsomely, although illegally, from ImClone stock. Waksal’s relatives sold a total of $400,000 in company stock before the news of the rejection emerged, a source close to the investigation said, on condition of anonymity … legal documents given to the committee show that domestic doyenne Martha Stewart also shed 3,000 ImClone shares. Stewart and Waksal have been romantically linked in the past.”[9] As a result of this report, the price of MSLO fell from $19.01 on June 6, 2002, to $11.47 on June 28, reducing the wealth of Stewart’s stockholders by 40%.

To understand this case it must be emphasized that it began with the accusation of insider trading. But after a year of thinking it over, the Justice Department decided not to press that charge, and once that decision was made, Stewart was legally no different than the hundreds of thousands of investors who had sold ImClone as the stock fell from over $75 to $58 before Stewart joined the crowd heading for the exits. At that point, the only legal charges left essentially accused her of trying to cover up for a crime she was never charged with in court.

Stewart’s own ethics remain a mystery for some. Only she, her broker Bacanovic, and his assistant Faneuil really know if Stewart told the truth in claiming that she had a stop-loss order to be put into effect when the ImClone stock hit $60. The prosecution made much of the fact that no evidence for the order (beyond the disputed long-entry) was found, but many such orders are informal. It is puzzling why Stewart would have lied about hers, but she may have. However, it was certainly never proven. The jury simply chose to believe Faneuil when he testified that he had been ordered by his boss Peter Bacanovic to pass on the information that Waksal and his family was dumping ImClone stock. It’s also puzzling why she would lie about being told of Waksal’s action, given the fact that, not being an ImClone board member or even an employee, she was at perfect liberty to take her broker’s advice and sell, regardless of his own motivations, and regardless whether the information was “legal” from her broker’s perspective or not. The fact that she had been a stockbroker thirty years earlier would have been no bar to her ordering the sale. Stewart’s friends and (few) public partisans concluded that she decided to fight the case instead of accept a plea bargain because she was in fact innocent of any significant crime. In other words, in her own mind, even if she did lie about the stop-loss order and did in fact hear of Waksal’s decision, she could not in fact be found guilty of insider trading. The Justice Department couldn’t dispute it, and Stewart was not so charged in the trial. That left the government with the obligation to continue the trial under the remaining charges, leaving Stewart in the position of defending herself against the accusation of having misled both ImClone’s and MSLO investors by denying having committed a crime for which she was not charged or tried.

The Ethics of ‘Insider Trading’

The picture most people have of insider trading is that of an executive or other high-level insider, perhaps a stockbroker working with an insider, using information not yet available to the public but soon to be available, to buy or sell stock in anticipation of an expected price jump or slump in response to that information when it does become public. The idea is that such trades are illegal because they are harmful to non-insider stockholders, both those who presently own stock and those who seek to own it, or seek to sell the stock they have. By eroding trust between the public with an interest in a company’s stock and those who run that company, the larger commercial world we all inhabit is hurt and made less productive. In short, it can turn the stock market into the rigged game is had often been for centuries. Short selling is often looked upon askance as being facilitated by insider trading, and because of that perception it is sometimes banned during market panics. It is worth noting that none of the principals of the ImClone case short any shares short. They just sold them, period. And it is worth re-noting that the charge of insider trading against Stewart was thrown out by the Justice Department.

However, there is much debate on whether insider trading (and short selling) is as bad as the public (and their representatives in Congress) assume. The Congressional angle is important. According to the Association for Investment Management and Research’s Standards and Practices Handbook, no statutory definition of insider trading exists in the United States. Instead, Congress has delegated what constitutes insider trading to the SEC, which decides on a case-by-case basis working through the courts.[10] To be sure, the SEC has written down a definition: to be in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information. That is why, in the case of Martha Stewart, that charge was dropped, but it didn’t stop the charge from being brought in the first place.

The question remains: is insider trading actually harmful? Some believe that the way to answer that question is to ask who the victim of a particular insider trade is. In the case of Martha Stewart, there was no victim, because she was only one of thousands who had been selling their stock in ImClone since early in the month of December, 2001. No victim was named by the U.S. attorney.[11] But more generally, if an insider is free to buy or sell a stock based on information known only to himself or a select few, that sale will change, (often only slightly) the price of the stock, thus making it reflect the latest information available for it. By prohibiting such sales, the price reflects old information and as such is a kind of statistical lie. If anything, enforcing such a ban on such a sale would tend to reduce trust of the market and so drive investors away.

The problem is one of asymmetry. Laws against insider trading necessarily target those who act in some way — by buying or selling. But it cannot catch those who use inside information to stay put — to not buy or not sell. The enforcement of such laws is thus stymied from the outset and can hardly help in its stated goal of making the marketplace fair. Instead, they have the effect of making it profoundly unknowable. By contrast, if people knew that insider trading was specifically permitted (as it was until the 1960s and so remains in many countries), everyone would know that the current price reflected all available information.

In Conclusion

To this day many people think Martha Stewart was guilty of insider trading, and that she tried to “cover it up” with “lies.” She may have lied, but not about anything fundamental. The issue is why she was charged at all. That is the elephant in the living room, and one that will be around as long as insider trading is considered a crime and selectively prosecuted, as it always must be.

Bibliography

Astrachan, Jim. Astrachan Gunst Thomas, “Martha’s Greek Tragedy.” Accessed June 16, 2012. http://www.agtlawyers.com/resources/articles/2004 articles/march2004.pdf.

Reynolds, Alan. Cato Institute, “Martha Stewart: Obstructing Injustice.” Last modified June 28, 2003. Accessed June 16, 2012. http://www.cato.org/publications/commentary/martha-stewart-obstructing-injustice.

Richman, Sheldon. Future of Freedom Foundation, “The Fraud of Insider-Trading Law.” Last modified September 5, 2003. Accessed June 16, 2012. http://www.fff.org/freedom/fd0309c.asp.

[1] Safety testing: to administer a drug to actual volunteer patients to experimentally test for side-effects and so determine the safe limits of the drug’s toxicity.

[2] Short sellers borrow shares of stock from a stockbroker (while paying a substantial rate of interest to do so) and then immediately sell those shares in the marketplace in the hopes that the stock will fall. If it does fall, the sellers then buy back the stock at the lower price, and pocket the difference, minus the interest, upon returning the stock to the broker. However, if the stock rises, then they must buy back the stock at the higher price, and so lose their money that way while still paying the interest as well. Short-selling as a long-term strategy is generally unprofitable because stocks tend to rise over time, reflecting gradual increases in national wealth.

[3] Reynolds, Cato Institute.

[4] Richman, Future of Freedom Foundation, p.2

[5] Mr. Stewart was later arrested on charges of having committed perjury in Mrs. Stewart’s trial. The issue was not the accuracy of the lab’s findings, but whether he had actually participated in the ink’s analysis. His case had no bearing on the use of the allegedly altered log as evidence or on the outcome of Mrs. Stewart’s trial.

[6] Hartridge was later found to have lied under penalty of perjury on his jury summons form, having been sued for failure to pay his bills; fired for possible drug use; and suspected or accused of embezzlement and assault.

[7] Astrachan, Astrachan Gunst Thomas .

[8] A German word for the pleasure taken in others’ misfortunes.

[9] As noted earlier, Waksal and Stewart’s daughter had once dated.

[10] After the Michael Milken conviction of 1990, when Congress decided to define insider trading formally by law, the SEC urged it not to do so because a clear definition would allow potential offenders to game the system. In other words, insiders are supposed to be governed by fear of a possible SEC criminal charge and not statutory regulations.

[11] This did not stop the SEC from stating, in its notice of the settlement of its civil suit against Stewart, that her fines would be added to “the fund for the benefit of the victims of this case.”