Is Martha Stewart a Buy?

Now that the prosecution's two star witnesses — Douglas Faneuil, the 28-year-old assistant to Stewart's Merrill Lynch securities broker, Peter Bacanovic, and Ann Armstrong, Stewart's personal assistant since 1998 — have finished their testimony, is the outcome of the case any clearer?

One barometer might be Wall Street itself. Faneuil began testifying on Feb. 3. Since then, shares of Martha Stewart Living have fallen 10% (as of noon Thursday) to $11.54. Does that slow leak indicate Wall Street is expecting to hear the "g" word from a jury foreman several weeks from today?

Before the trial started, investors seemed to be betting that Stewart would be let off with a mere slap on the wrist. Shares of Martha Stewart Living surged 30% from Jan. 2 to Feb. 3. Analysts tracking the company took notice. "For better or worse, investors appear to be more optimistic that Martha will beat the charges," wrote Morgan Stanley's Douglas Arthur in a Feb. 3 research note in which he reiterated his Underweight call. "There seems to be greater focus among the media on the fragility of the government's case." Arthur wrote that, of course, before the prosecution had rolled out its two star witnesses.

'I want to sell my shares.'
It all comes down to a single phone call. Fanueil testified that on Dec. 27, 2001, Bacanovic instructed him to call Stewart to tell her that Samuel Waksal, then chief executive of ImClone Systems (IMCL) and a client of Bacanovic, was dumping shares of his own company.

"Peter thought you might like to act on the information that Sam Waksal was trying to sell all his shares," Faneuil said he told Stewart, who called the Merrill Lynch office in Midtown Manhattan from her private jet on a trip to Mexico. Stewart then asked for ImClone's share price, the broker's assistant testified. Faneuil told her, and she said, "I want to sell my shares." The following day, ImClone's stock plummeted on news of the Federal Drug Administration's rejection of the company's colorectal-cancer-treatment drug, Erbitux.

When questioned by authorities about the trade weeks later, Stewart and Bacanovic said they had an agreement to sell if ImClone's stock price ever fell below $60, using a common trading practice known as a stop-loss order. (Bacanovic initially said the sale was for tax-loss purposes, a claim he later retracted after realizing that Stewart made a profit on the sale.) Stewart's 3,928 ImClone shares traded at $58.43 when they were sold.

But the feds weren't buying the stop-loss story, and neither was the investment community. Shares of Martha Stewart Living, which fetched about $26 in February 2002, began to plunge in sync with the reputation of its founder, bottoming out around $6 in October of that year. By all appearances, Stewart had acted on inside information.

Stewart, however, has never been criminally charged with insider trading, and attorneys following the case say that's a problem for the prosecution. "That leaves a huge gap in [the prosecution's] argument, and it's going to cause some questions in the jury's mind," says Henry Mazurek of the Law Offices of Gerald Shargel. "The government believes so much that she lied to them and hindered their investigation, and yet they didn't charge the underlying crime that they say is the reason for the lie."

It's such a crucial part of the defense, in fact, that Stewart's lawyer, Robert Morvillo, moved for a mistrial on Wednesday because the U.S. district judge hearing the case, Miriam Cedarbaum, has barred the defense from making more arguments to the jury that no insider trading took place. Morvillo maintained that Stewart's entire defense has been constructed around that theme and that restricting testimony about it is unfair. "That's the way we set up our defense in this case," Morvillo told the judge, who swiftly rejected the motion.

Mike Tuteur, a law partner with the firm Epstein Becker & Green, says that legally, it doesn't matter whether or not Stewart actually engaged in insider trading — what matters is that she may have lied about her actions to investigators. "If I lie to the government, that's a crime," says Tuteur. "The fact that you're lying about something that's not been charged does not in and of itself save Martha."

Still, says Tuteur, the lack of an insider-trading charge may sway some of the jurors on an emotional level. "The fact that they haven't charged her with insider trading is significant in that it allows the defense to say that the government doesn't have the courage of its convictions," he says.

What about Faneuil's testimony that Stewart knew about Waksal's stock sales? Tuteur doesn't think that's enough to convict Stewart of the obstruction charge. "Morvillo did a good job in suggesting that Faneuil really can't bring Martha down," he says. "He's done a nice job in laying out for the jury that the prosecution can't use Faneuil's testimony" to prove Stewart guilty beyond a reasonable doubt.

'Put it back the way it was.'
Of the two federal counts against Stewart, obstruction will be the easiest to prove, says Tuteur. "There is almost uniform consensus around the defense bar that [the securities-fraud charge] is truly overreaching on the part of the government," he says.

But the prosecution did make some significant headway on the obstruction count with Armstrong's testimony on Tuesday. The former assistant told jurors that she witnessed Stewart alter a message from Dec. 27, 2001, about the ImClone trade. She testified that on Jan. 31, 2002, Stewart opened a telephone message log on Armstrong's computer and changed a message that read "Peter Bacanovic thinks ImClone is going to start trading downward," to "Peter Bacanovic re: imclone." But Stewart apparently had a change of heart and told Armstrong to "put it back the way it was."

Four days later, on Feb. 3, Stewart told SEC and Justice Department investigators that she had no recollection of any phone-log message from Bacanovic, a statement that appears to be false after Armstrong's testimony.

Margaret Finerty, a partner with the Getnick & Getnick law firm and former criminal-court judge in Manhattan, says Armstrong's testimony may convince jurors that Stewart was engaged in a cover-up. "The fact that [Stewart] attempted to change the message does hurt her," says Finerty. "The jury has no reason not to believe [Armstrong]. She has no axe to grind."

Jack Chin, a professor of law at the University of Arizona and an expert in criminal law, offers a more extreme view of Armstrong's testimony. "It was absolutely devastating," says Chin. "It's her own assistant, Martha Stewart's friend and employee. This is not somebody who has pled and made a deal. It's highly credible testimony."

Chin says that if the jury believes Armstrong, Stewart could be found guilty of a felony that could carry a statutory maximum five-year prison sentence. "One of the crimes that she was indicted for was violation of U.S. code 18USC1001, and that is the federal investigator's friend. It criminalizes making a false statement to a federal investigator."

Since it appears hard to believe that Stewart could possibly have forgotten about the incident at Armstrong's desk, Stewart's defense team is clearly in a tight spot right now. Its current tactic, it appears, is something of a legalistic duck and faint — it has pointed out to the jury that Stewart wasn't presented with a copy of SEC Form 1662, which states that lying to federal investigators is a crime, before speaking with them.

Mazurek agrees that Armstrong's testimony was highly damaging to Stewart, but he says the allegations weren't a surprise, and represent the best of the government's case. "The question is, can Martha turn this around as the case moves forward and give reasons for her actions?" he says.

Hang 'em High
Now, of course, everyone wants to know: Will Martha testify?

"It's the toughest question for every defense attorney to put your client on the stand," says Tuteur, who thinks that in the end Stewart will testify to counteract the negative impression Armstrong and Faneuil's testimony has had on the jury. As Tuteur points out, the defense need convince only one juror to get a hung jury, and "a hung jury is a huge win for the defense," he says.

And that would be a huge win for Martha Stewart Living. Dennis McAlpine, a retail analyst with independent-research firm McAlpine Associates, based in Scarsdale, N.Y., thinks the stock of Martha Stewart Living will shoot up after the trial even if there is a guilty verdict, as long as there's no prison sentence. "The general thinking seems to be that she won't go to jail even if she is convicted," says McAlpine. "And there again, I think you get some increase in price."

But would McAlpine recommend holding the stock after that short boost? Not for a minute. "I'd short the hell out of the stock if it went up much," says the analyst, who rates Martha Stewart Living a Sell. "All the numbers seem to indicate that consumers are getting tired of the Martha Stewart product lines." (McCalpine doesn't own shares of Martha Stewart Living; McAlpine Associates doesn't do investment banking.)

Or, as Morgan Stanley's Arthur put it in his Feb. 3 report: "Let's face it, watching Martha on TV tending to a garden isn't exactly can't-miss TV anymore." (Arthur doesn't own shares of Martha Stewart Living; Morgan Stanley has an investment-banking relationship with the company.)

We'll have to wait for the trial's conclusion to see if that's truly the case. Proceedings resume on Friday.