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Martha is Not Guilty

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Tags Financial MarketsLegal System

06/12/2003Alexandre Padilla

A federal grand jury in New York has indicted Martha Stewart on five criminal counts of securities fraud, conspiracy and making false statements to federal agents. At the same time, the Securities and Exchange Commission has also decided to file a civil case in a New York federal court against Martha Stewart and has accused her of illegal insider trading. 1 ​Her broker, Peter Bacanovic, was charged in the same indictment as Ms. Stewart.

Of course, most of the commentators have welcomed this indictment. They argue that what Martha Stewart has done is unfair and immoral regarding the ImClone System Inc.'s investors and market investors in general. While I have argued against Martha Stewart's prosecution before (see Padilla, The Modern Witch Hunt), I would like to offer again some new arguments to explain why Martha Stewart should not be indicted on the charges of illegal insider trading.


Not only is the case against Martha Stewart based on circumstantial evidence but, more importantly, such circumstantial evidence is very sketchy.2 Here is the  evidence on which the SEC and the Federal authorities are basing Martha Stewart's prosecution. First, we know that in exchange for his testimony, Douglas Faneuil, Peter Bacanovic's assistant, told the SEC that Martha Stewart telephoned Peter Bacanovic's office and had a conversation with Douglas Faneuil, who apparently told him that ImClone's CEO, Samuel Waksal, was trying to sell all his ImClone stock that he held at Merrill Lynch.

According to Mr. Faneuil, Martha Stewart promptly instructed him to sell all 3,928 shares of her ImClone's stock. We also know that the next day, ImClone announced that the Food and Drug Administration had decided not to accept ImClone's Erbitux application for filing. By the close of the next trading day, Monday, Dec. 31, 2001, the price of ImClone stock dropped 16% to $46 a share, after having been down 18% at the opening.

By selling when she did, Ms. Stewart avoided losses of $45,673. Another piece of evidence that Martha Stewart engaged in illegal insider trading is that she apparently received a message from Peter Bacanovic on her answering machine stating that "Peter Bacanovic thinks ImClone is going to start trading downward" and allegedly changed it to "Peter Bacanovic re ImClone" by deleting part of the message. Therefore, based on all these pieces of evidence, Martha Stewart's prosecutors argue that she engaged in illegal insider trading and knew perfectly well that Peter Bacanovic had communicated material nonpublic information to her in breach of his fiduciary duty owed to Merrill Lynch clients.

I wonder since when Federal authorities have been equipped with a crystal ball because when I read these different pieces of evidence presented in the New York federal court I only see at most speculations. Let's examine the first piece of evidence coming from Peter Bacanovic's assistant, Mr. Faneuil. Regarding his testimony, the only thing that we know is that Samuel Waksal sold his ImClone shares and Mr. Faneuil told Martha Stewart that ImClone's CEO sold his shares.

Mr. Faneuil, who, by the way, settled a civil securities-fraud case, without admitting or denying the allegations, did not tell Martha Stewart why Samuel Waksal sold his shares nor did Peter Bacanovic.3 One might argue that the following-day announcement that the FDA's rejection of ImClone's Erbitux application for filing might explain why Samuel Waksal and Martha Stewart sold their shares.

The timing of the two events was indeed notable. However, the fact that the timing between these two events was very good does not mean that there is a causal relation between the two events. One might speculate as much he wants about the two events but still there is no way to know whether these two events are linked.

Regarding the voicemail left by Peter Bacanovic to Martha Stewart, one might wonder how the prosecutors know that it has been partially deleted. Did they have access to the original message? Moreover, there is another problem. The supposedly original message left by Peter Bacanovic neither mentions Samuel Waksal's selling transactions nor it does make a reference to the FDA's event.

The original message clearly says: "Peter Bacanovic thinks ImClone is going to start trading downward." Where in this message is it said that Samuel Waksal sold his ImClone shares? Where in this message is it said that the FDA rejected ImClone's Erbitux application for filing? When I read this message I only read that Martha Stewart's broker thinks that ImClone's share price is going to decline. I do not know why he is thinking that and, based on this message, there is no way for me to know why. So, for me, I do not see any breach of fiduciary duty in this message nor do I see any communication of inside information.

In conclusion, it must be very nice to work for the government because that entitles you to a crystal ball. I always wanted a crystal ball so I would stop stressing out about every uncertainty I have in my life. But, ultimately, all the circumstantial evidence provided by the prosecutors in New York amounts to nothing.


The insider trading laws themselves are inconsistent. The prosecutors are telling us that Peter Bacanovic and his assistant have committed a breach of fiduciary duty with regard to Merrill Lynch's clients by disclosing to Martha Stewart that Samuel Waksal sold his ImClone shares.  In other words, Peter Bacanovic and Mr. Faneuil have breached the duty of keeping confidential Samuel Waksal's transactions. Therefore, the information received by Martha Stewart was illegally acquired and hence she has no right to base her decision to sell her shares on this information.

Well, this argument in light of the insider-trading laws is correct. However, that does not mean that insider-trading laws are right, and it means even less that insider-trading laws are consistent. First, in virtue of Section 16(b) of the Securities Exchange Act of 1934, insiders such as Samuel Waksal (Section 16(a) of the Securities Exchange Act of 1934 defines insiders as every director and officer of the corporation (plus any owners of 10% or more of the equity) are required to report their transactions to the SEC within 30 days and the SEC publishes monthly in the Insider Report this information to the public (so does the Wall Street Journal which publishes every week insiders' transactions in the section Insider Trading Spotlight).

So, in other words, while Peter Bacanovic and his assistant should not have disclosed this information to Martha Stewart, she would have known this information later on. This fact in itself raises two other questions. First, if the government is right about the fact that Peter Bacanovic should not have breached his duty of confidentiality, why does the government require insiders to report all their transactions to the SEC, which renders those transactions public by publishing them? Is not the government breaching some kind of fiduciary duty?

Assume that there is a good argument to justify the fact that insiders must report their transactions to the SEC. Why is the government not keeping this information confidential? In other words, the government is telling us: "Do what I tell you to do but do not do what I do!"  

The second question is related to the client-broker relation existing between Martha Stewart and Peter Bacanovic. Is it not the role of a broker to serve the best interests of Martha Stewart? After all, think about what would have happened if Peter Bacanovic did not advise Martha Stewart to sell her shares. She would have found out later on that Samuel Waksal had sold his shares and she would have found out that the FDA rejected ImClone's Erbitux application for filing. If I were a shareholder and my broker did not advise me to sell my shares knowing such material information, public or not, I would sue my broker right away or at least fire him and go somewhere else where I think my interests would be better served.

The government tells us that Peter Bacanovic broke his fiduciary duty owed to Merrill Lynch's clients and, in particular, Samuel Waksal. Actually, I do not think Peter Bacanovic broke any fiduciary duty; he actually did his job by advising Martha Stewart to sell her shares. Again, even if Peter Bacanovic according to the law should not have told Martha Stewart that Samuel Waksal had sold his ImClone shares, Martha Stewart would have found out later (actually, we are not even sure that is the case since Mr. Faneuil never admitted or denied the allegations). It is by not advising Martha Stewart to sell her shares that Peter Bacanovic would have violated his fiduciary duty.


The third reason is related to the recent rules adopted by the SEC in 2002 (Rule 10b5-1 and 10b5-2) and the U.S. Supreme Court decision in O'Hagan v. United States (U.S. No. 9632—1997). In 1997, the U.S. Supreme Court, relying on the misappropriation doctrine, argued in the O'Hagan case that insider trading was illegal only when the insider had not disclosed his intentions to trade on the basis of inside information to the legitimate owners of such information: the shareholders.

Following the U.S. Supreme Court decision, the SEC has officially adopted the same approach to insider trading with the Rules 10b5-1 (CFR 240.10b5-1) and 10b5-2 (CFR 240.10b5-2). And, as I have already argued (see Padilla, The Modern Witch Hunt), such an argument is only valid if insiders are not themselves shareholders, which is not the case today in most corporations. Today, in most corporations, insiders are themselves owners of stocks or stock options and, as a consequence, owners of the corporation information as well.

Therefore, when we look at the Martha Stewart case, we are stunned to learn that she is being prosecuted for illegal insider trading. Is not the decision by the SEC and the New York court to indict Martha Stewart for illegal insider trading in contradiction with the texts? As far as I know, Martha Stewart was an owner of the corporation since she had almost 4,000 shares.

So if she was an owner of ImClone and, as the law texts and U.S. Supreme Court decision argued, she is also the legitimate owner of the inside information (here in the case, the fact that the FDA rejected ImClone's Erbitux application for filing), there is no reason to prosecute her. She did not have to disclose to the legitimate owners of ImClone her intentions to trade on such information since she is also an owner. The current prosecution of Martha Stewart is in complete contradiction with the texts (to be sure, one might argue that these texts are so complex and so unclear that anybody can find anything he wants to justify his case).

To conclude, there is no real argument for prosecuting Martha Stewart. Whether we look at the very sketchy circumstantial evidence, the fiduciary duty argument, the proprietary information doctrine argument, none of these arguments can justify the prosecution of Martha Stewart. The prosecution of Martha Stewart and others before her is nothing more than the reflection of the growing anticapitalist mentality in our society that Mises warned us about. This mentality has been growing for a long time and, unfortunately, its main effect is that it has been slowing down the progress of the civilization.

  • 1. See SEC v. Martha Stewart and Peter Bacanovic. 03 CV 4070 (NRB) Complaint. June 4, 2003.
  • 2. Circumstantial evidence has been traditionally accepted in courts to prosecute insider trading cases.
  • 3. As part of the settlement, Mr. Faneuil was barred from the securities industry and did not pay a fine. He previously plead guilty to a misdemeanor and agreed to cooperate with criminal investigators. Such a settlement between the SEC and Mr. Faneuil should send a signal to the jury that the government prosecutors are nothing more than blackmailing such witnesses when they agree to be lenient with them IF they agree to help the government catch a "bigger" fish (that is, a big celebrity instead of Mr. Nobody). One might wonder what would have happened if Mr. Faneuil had refused to cooperate with the government and had denied that he communicated to Martha Stewart any information regarding Samuel Waksal's transactions. Such a settlement strongly undermines the credibility of Mr. Faneuil.
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