Imagine if you had knowledge that a Covid-19 vaccine trial was about to fail several days prior to that information becoming public knowledge. It might be a good time to sell any shares of the company offering the vaccine, right?

This was the case with Martha Stewart who served time in prison after being indicted for (but not convicted of) securities fraud in 2002. At the heart of the case was Stewart selling her stock in the biotech company, ImClone Systems.

What Happened?

At first glance the events surrounding Stewart’s case seem very cut and dry. In late 2001, Stewart sold all of her shares in the biotech company ImClone Systems. Two days after the sale, news broke that the U.S. Food and Drug Administration (FDA) was not going to be reviewing ImClone’s application for its cancer drug Erbitux. This was the leading drug in the company’s pipeline. 

The stock plummeted 18% in the first day of trading after the news broke. Stewart manages to avoid a $45,673 loss. 

In early 2002, Stewart and her Merrill Lynch broker Peter Bacanovic told investigators that the transaction was based on a “stop-loss” order t to sell the shares if they fell to $60 per share. 

However, Stewart wasn’t the only one selling. Prior to Stewart’s sale, ImClone’s founder and friend of Stewart, Sam Waksal received a tip regarding the FDA’s action. Waksal instructed Bacanovic, who was also his Merrill Lynch broker, Peter Bacanovic to transfer nearly $5 million in stock to his daughter’s account. 

Of course, the snowball kept rolling. His daughter requested Bacanovic to sell $2.5 million of the stock she held in the company. And this is where the case against Stewart begins. According to phone records, Bacanovic informed Stewart of the FDA rumor minutes after Waksal’s daughter sold her shares. And only minutes after that, Stewart’s trade was executed. 

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How Was the Fraud Discovered?

Whenever the Securities and Exchange Commission (SEC) notices trading activity like the kind involving ImClone, the antennae go up for insider trading. There are some coincidences that just aren’t coincidences. 

The heart of the insider trading case against Stewart came down to the information she received from Bacanovic. Was this simply the timely execution of a stop-loss order, or was it insider trading? Part of the problem was that investigators could not find evidence of a written stop-loss order. And the other problem for Stewart was phone records that showed calls from Bacanovic right around the time the sale was executed.

The pressure against Stewart didn’t really increase until later in 2002. At that time Bacanovic’s assistant, Douglas Faneuil, told Merrill Lynch legal counsel that Bacanovic had applied pressure on him to lie about the stop-loss order. Faneuil told federal prosecutors that he, in fact, was prompted to advise Stewart that Waksal family members were selling their stock and that she should consider following suit. 

Faneuil ultimately pled guilty to taking a payoff to keep quiet about the Stewart stock trade. This led to both Stewart’s and Bacanovic’s indictment on nine federal counts.

What Were the Consequences For Martha Stewart?

Ultimately the charges of securities fraud were thrown out. However, Stewart was still found guilty on four counts of obstruction of justice and lying to investigators. Ms. Steward served five months at the Alderson Federal Prison Camp in West Virginia. After completing that sentence, she served five months of house arrest and two years of probation. 

Conclusion

Insider trading is easy to suspect, but can be difficult to prove. In the case of Martha Stewart, the case came down to what investigators could prove. For Stewart to be charged with securities fraud, investigators would have had to prove she acted upon nonpublic information. 

In this case, she acted upon knowledge of Waksal’s actions – but not explicit knowledge of the FDA decision. And since Stewart, though friends with Waksal, was not on ImClone’s board of directors, she had no duty to avoid trading based on that information. 

Prosecutors ultimately were able to convince a jury that Stewart had acted on a tip that she knew would breach her broker’s duty. And that means she knew that her actions, at best, were unethical and possibly illegal.