Empire Lost

marthastuart2Last week my wife and I were confronted with the challenge of  hosting a Christmas party for 24 of our relatives.  We thought we’d serve a standing prime rib roast to the guests and turned to a Martha Stewart Cooking School episode on PBS for preparation guidance.  Needless to say, the roast was delicious but seeing Stuart again after all this time got me thinking about her classic insider trading case of what now seems so long ago.

In June 2002, Martha Stewart began to wrestle with allegations that she had improperly used inside information to sell a failed personal stock investment to the unsuspecting investing public. That was when her personal friend Sam Waksal was defending himself against Securities and Exchange Commission (SEC) allegations that he had tipped off his family members so they could sell their shares of ImClone Systems Inc. just before other investors learned that ImClone’s stock was about to tank. Observers presumed that Stuart was also tipped off and, even though she proclaimed her innocence, the rumors would not go away. On daily TV as the reigning guru of homemaking, Ms. Stuart was the multimillionaire proprietor, president, and driving force of Martha Stewart Living Omnimedia Inc. (MSO), of which, on March 18, 2002, she owned 30,713,475 (62.6 percent) of the class A, and 30,619,375 {100 percent) of the class B shares.

On December 27, 2001, her class A and class B shares were worth approximately $17 each, so on paper her MSO class A shares alone were worth over $500 million. Class B shares were convertible into class A shares on a one to-one basis. What was not known was that Stewart had sold 3,928 shares of ImClone for $58 each on December 27, 2001.  This was not public until the information surfaced in June 2003.  The sale generated $227,824, and she avoided losing $45,673 when the stock price dropped the next day.  The whole sorry episode over this relatively small amount of money wound up causing her endless personal grief and humiliation, dealt a devastating blow to her reputation, and precipitated a punishing drop to $5.26 in the MSO share price.

As some of your probably remember, it turned out that Stuart had made an investment in ImClone, a company that was trying to get the approval of the U.S. Food and Drug Administration (FDA) to bring to market an anti-colon cancer drug called Erbitux. Samuel Waksal, then the CEO of ImClone and a friend of Stuart’s, was apparently warned on or close to December 25, 2001, that the FDA was going to refuse to review Erbitux. Per later SEC allegations, Waksal relayed the information to his family so they could dump their ImClone shares on the public before the official announcement. Martha claimed (and still claims) that she didn’t get any early inside information from Waksal, but regulators believed that she may have either gotten it from her broker or from her broker’s aide. The activities of several of Waksal’s friends, including Stuart all came under almost immediate investigation by the SEC.

Waksal was arrested on June 12, 2002, and charged with “nine criminal counts of conspiracy, securities fraud and perjury, and then freed on $10 million bail. In a related civil complaint, the SEC alleged that Waksal “tried to sell ImClone stock and tipped family members before ImClone’s official FDA announcement on Dec. 28.”  Per the SEC, two unidentified members of Waksal’s family sold about $10 million worth of ImClone stock in a two-day interval just before the announcement. Moreover, Waksal also tried for two days to sell nearly 80,000 ImClone shares for about $5 million, but two different brokers refused to process the trades. Stuart denied any wrongdoing. She was quoted as saying: “In placing my trade I had no improper information…. My transaction was entirely lawful.”  She admitted calling Waksal after selling her shares, but claimed: “I did not reach Mr. Waksal, and he did not return my call.”  She maintained that she had an agreement with her broker to sell her remaining ImClone shares “if the stock dropped below $60 per share.” Stuart’s viewing public, however, was skeptical. She was asked embarrassing questions when she appeared on TV for a cooking segment, and she declined to answer saying: “I am here to make my salad.”

Martha’s interactions with her broker, Peter Bacanovic, and his assistant, Douglas Faneuil, quickly came under scrutiny. Merrill Lynch & Co. suspended Bacanovic (who was also Sam Waksal’s broker) and Faneuil, with pay, in late June. Later, since all phone calls to brokerages are taped and emails kept, it appeared to be damning when Bacanovic initially refused to provide his cell phone records to the House Energy and Commerce Commission for their investigation. Then, on October 4, 2001, Faneuil “pleaded guilty to a charge that he accepted gifts from his superior in return for keeping quiet about circumstances surrounding Stewart’s controversial stock sale.”  Faneuil admitted that he received extra vacation time, including a free airline ticket from a Merrill Lynch employee in exchange for withholding information from SEC and FBI investigators.

Per court records:

“On the morning of Dec. 27, Faneuil received a telephone call from a Waksal family member who asked to sell 39,472 shares for almost $2.5 million. Waksal’s accountant also called Faneuil in an unsuccessful attempt to sell a large block of shares. Prosecutors allege that those orders “constituted material non-public information.” They also allege that Faneuil violated his duty to Merrill Lynch by calling a “tippee” to relate that Waksal family members were attempting to liquidate their holdings in ImClone. That person then sold “all the tippee’s shares of ImClone stock, approximately 3,928 shares, yielding proceeds of approximately $228,000.”

One day later, on October 5th, it was announced that Stuart had resigned from her post as a director of the New York Stock Exchange (a post she held only four months) and the price of MSO shares declined more than 7 percent to $6.32 in afternoon trading. From June 12th to October 12th, the share price of MSO declined by approximately 61 percent. Stuart’s future took a further interesting turn on October 15th, when Sam Waksal pleaded guilty to six counts of his indictment, including: bank fraud, securities fraud, conspiracy to obstruct justice, and perjury. But he did not agree to cooperate with prosecutors, and did not incriminate Stuart. Waksal’s sentencing was postponed until 2003 so his lawyers could exchange information with U.S. District Judge William Pauley concerning Waksal’s financial records.  After October 15th, the price of MSO shares rose, perhaps as the prospect of Stuart’s going to jail appeared to become more remote, and/or people began to consider MSO to be more than Stuart and her reputation. The recovery from the low point of the MSO share price in October to December 9, 2002, was about 40 percent.

Stuart still had a lot to think about, however. Apparently, the SEC gave Stuart notice in September of its intent to file civil securities fraud charges against her. Stuart’s lawyers responded and the SEC deliberated. Even if Martha were to get off with a fine, prosecutors could still bring a criminal case against her in the future. It is an interesting legal question, however, that if Stuart had simply pled guilty to the civil charges, would she have avoided criminal liability completely? On June 4, 2003, Stewart was indicted on charges of obstructing justice and securities fraud. She then quit as Chairman and CEO of her company, but stayed on the Board and served as Chief Creative Officer. She appeared in court on January 20, 2004, and watched the proceedings throughout her trial. In addition to the testimony of Mr. Faneuil, Stewart’s friend Mariana Pasternak testified that Stewart told her Waksal was trying to dump his shares shortly after selling her ImClone stock. Ultimately, the jury did not believe the counterclaim by her broker, Peter Bacanovic, that he and Stuart had a prior agreement to sell ImClone if it went below $60. Although the judge dismissed the charge of securities fraud for insider trading, on March 5, 2004, the jury found Stewart guilty on one charge of conspiracy, one of obstruction of justice, and two of making false statements to investigators.

The announcement caused the share price of her company to sink by $2.77 to $11.26 on the NYSE. Stuart immediately posted the following on her website:

“I am obviously distressed by the jury’s verdict, but I continue to take comfort in knowing that I have done nothing wrong and that I have the enduring support of my family and friends. I will appeal the verdict and continue to fight to clear my name. I believe in the fairness of the judicial system and remain confident that I will ultimately prevail.”

Stuart was subsequently sentenced to 5 months in prison and 5 months of home detention-a lower than maximum sentence under the U.S. Sentencing Guidelines-and she did appeal. Although she could have remained free during the appeal, on September 15, 2004, she asked for her sentence to start immediately so she could be at home in time for the spring planting season. Martha’s appeal cited “prosecutorial misconduct, extraneous influences on the jury and erroneous evidentiary rulings and jury instructions” but on January 6, 2006, her conviction was upheld.

Stuart may continue to disagree with the verdict to this day but there is little doubt that the allegations and her subsequent convictions had a major impact on her personally, and on the fortunes of MSO and the shareholders that had faith in her and in her company. Assuming a value per share of $13.50 on June 12th, the decline to a low of $5.26 in early October 2003 represents a loss of market capitalization (reputation capital) of approximately $250 million, or 61 percent. The value of MSO’s shares did return to close at $35.51 on February 7, 2005, but fell off to under $20 in early 2006. Per a New York brand-rating company, the Martha Stewart brand reached a peak of 120 (the baseline is 100) in May 2002, and sank to a low of 63 in March 2004.

As my wife and I can attest, Stuart has returned to TV with a version of her usual homemaking and design shows, her new Martha Stewart Cooking School and related books.  Her products and magazines continue to be sold.  Still, what a catastrophe for so many to save just $45,000.

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