Updated from 3:42 p.m. EDT

The lead director of Martha Stewart Living Omnimedia ( MSO), defending his embattled chief on one of her worst days, told shareholders gathered Tuesday that a possible indictment won't force Martha Stewart from the company she founded.

Former Sears CEO Arthur Martinez had the awkward task of presiding over Martha Stewart Living's annual meeting on the same day the company announced that its world-famous CEO is likely headed for more trouble. Federal prosecutors are planning to seek an indictment of Stewart, and civil charges from the Securities and Exchange Commission may be pending as well, the company said.

The case stems from Stewart's sale of ImClone Systems ( IMCLE) stock in December 2001, just before bad news caused the biotech's shares to plunge. The highly publicized incident has been hanging over Stewart and her company's head for more than a year, but Tuesday's developments were a dramatic setback for Stewart, who has steadfastly denied wrongdoing and reportedly sought a settlement that would clear her of criminal charges.

At Tuesday's shareholder meeting, Martinez sought to rebut market rumors that Stewart would depart as the government prepares to take legal action against her. He told shareholder such talk was "categorically untrue" and reiterated those remarks in a statement to reporters, who were barred from the annual meeting.

The company received expressions of strong support from shareholders, Martinez added, emphasizing that Martha Stewart Living's business is strong and its balance sheet solid. Martinez said shareholders re-elected Stewart and the other members of the company's board.

Still, investors expressed frustration as they surveyed the legal thicket ensnaring the company's namesake. Martha Stewart Living shares dropped $1.68 to close at $9.52. The day's 15% decline wiped out the stock's gains since settlement talk between Stewart and the government were reported in mid-May, leaving the shares at half their level of a year ago -- just before news of the government inquiries emerged.

Some Martha Stewart shareholders did express their solidarity with the company's beleaguered CEO at Tuesday's annual meeting, but others noted a strain of dissent at the gathering, which took place at a midtown Manhattan hotel.

"A lot of people stood up in the Q&A and said they were disappointed she wasn't there," shareholder Karen Skoglund said of Stewart. Skoglund, who noted that Stewart made a brief virtual appearance at the meeting via videotape, said she would continue to hold the stock.

Shareholder John Hoitsma was more bullish, saying that Stewart is being railroaded and that the stock is a strong value at its recent level.

Analysts said that while the latest developments in the long-running saga hardly doom Stewart's company, neither will they enhance its image with potential buyers of her magazines and tablecloths.

Still, observers noted that federal prosecutors will have a heavy burden in pursuing a case against Stewart. Those arguments were buttressed by the uncovering of a little-known New York court case that legal experts said could be central to Martha Stewart's fate.

Slaying the Queen

The big question on Wall Street has been why it's taken so long for the feds to move against Stewart, given that the case has been making headlines for more than a year. Observers expect Stewart, who has insisted in the past that she has done nothing wrong, to face either obstruction of justice or insider trading charges. Robert Morvillo, the well-known New York white-collar defense lawyer who is representing Stewart, couldn't be reached Tuesday for comment.


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Legal experts attributed the delay to the high-profile nature of the defendant and the apparent lack of a significant paper trail. Lawyers say prosecutors tend to move deliberately in making a case against a celebrity or politician because they risk embarrassing themselves by mounting a prosecution on flimsy charges and then losing.

Indeed, there's an old saying in the legal world that you "don't go after the king unless you can slay him."

Complicating matters were efforts this week by Stewart lawyers to plead their case with prosecutors in Washington. But Seth Taube, a former federal prosecutor who is now a white-collar criminal defense specialist at McCarter & English in Newark, N.J., said the attempt by Martha Stewart's defense lawyers to avoid indictment was "doomed." The Justice Department has a "zero tolerance policy for securities fraud and hasn't backed down since before Enron," Taube says.

Also, defense lawyers say it appears that much of the case against Stewart may be based on circumstantial evidence or testimony from less-than-savory witnesses, including Douglas Faneuil, the former assistant to Stewart's broker at Merrill Lynch. Faneuil has pleaded guilty to a misdemeanor charge and has agreed to cooperate with prosecutors.

Faneuil reportedly has told prosecutors that he told Stewart of former ImClone chairman Sam Waksal's attempt to sell much of his stock prior to the release of a negative regulatory ruling on a key cancer-fighting drug. Waksal pleaded guilty to insider trading charges last year. He is scheduled to be sentenced June 10.

A lawyer who didn't want to be identified said Stewart's is a tough case because much of the evidence seems to be based on "oral" communications. That's one reason many speculate Stewart won't be charged with insider trading, but rather with obstruction of justice.

Privilege

Another reason prosecutors may have difficulty filing insider trading charges could be a recent ruling from a federal judge in New York. In a decision handed down on May 1, U.S. District Judge Lewis Kaplan held that some conversations between the target of a grand jury investigation and a public relations firms can be subject to the attorney-client privilege, if they relate to the handling of the "client's legal problems."

The decision, reported first in Tuesday's edition of The New York Law Journal, doesn't identify the alleged target of the investigation or the PR firm in question. But in concealing the identities of the parties, Judge Kaplan said the investigation is being led by Southern District U.S. Attorney James Comey -- the prosecutor leading the Stewart investigation. The judge also said the investigation in question "has been a matter of intense press interest and extensive coverage for months."

The speculation in the New York legal community is that decision stems from the grand jury investigation of Stewart and could complicate the prosecution's case.

The ruling stems from a March 24 subpoena served by Comey's office on a public relations firm, in which prosecutors sought to compel one of the firm's employees to testify before the grand jury. Comey had sought to force the employee to testify about some of her communications with the target of the investigation. But the employee refused, saying her communications were protected by the attorney-client privilege.

One of Stewart's main publicists is Susan Magrino, who does public relations work for many high-profile people and celebrities. Magrino wasn't immediately available for comment.

Judge Kaplan said the public relations firm had been hired because the attorneys for the target of the investigation were concerned that "unbalanced and often inaccurate press reports about the target created a clear risk that the prosecutors and regulators conducting the various investigations would feel public pressure to bring some kind of charges against her."

The judge said that the work of defense lawyers would be undermined if they "were not able to engage in frank discussions of facts and strategies with the lawyers' public relations consultants."

Last summer, when the probe began heating up, Stewart hired Morvillo as her lawyer and also retained the services of the Brunswick Group to provide public relations services, in addition to Magrino, her longtime publicist. Brunswick said it no longer represents Stewart.

Brand Management

Analysts were focusing on potential damage in the firm's relationship with the slimmed-down Kmart, which recently emerged from bankruptcy, and with advertisers in the Martha Stewart magazines. The company's publishing business accounts for the lion's share of its revenue.

Terrance MacKay, an analyst at Morningstar, says consumers aren't likely to stop buying Martha's wares as a result of the charges. But he believes the business will suffer over the long term unless Stewart is completely exonerated.

"It's not a question of whether consumers want to do business with her -- it's a question of whether Kmart and other retailers want to do business with her," MacKay said. "The firm's competitive advantage is built upon her reputation. As long as that reputation is harmed, it hurts the company's business."

Indeed, much of the value of retail and media company stocks -- especially those tethered to one individual -- hinges on the desirability and sustainability of a brand name. Some analysts say branding is a matter of "economic good will," and that it will take time to assess the damage to the Martha Stewart brand and its toll on the company's intrinsic value.

"The Martha Stewart brand still has value, but not the value it once did," said John Linder, an analyst for Alsin Capital Management, which holds no positions in Martha Stewart shares.

Of course, the myth of Martha Stewart as a sweet-natured doyenne of domesticity was punctured long before today's news, so the damage to the brand may be largely priced in. "At this point, as long as she doesn't get dropped by Kmart or her other sponsors, I don't see her brand being further damaged," said Linder, who adds that a mitigating factor is that Stewart's problems were personal -- "not business. It's not like she's putting out some bad candles and people are getting sickened."

In any case, Stewart appears unlikely to end up in the poor house. Even were Stewart to step down in the face of a possible criminal indictment, she probably wouldn't walk away company empty-handed. The company's most recent proxy statement says the executive is entitled to receive an "immediate lump sum cash payment" equal to the sum of her unpaid salary, three times her annual base salary and at least an additional $5 million. She would forfeit the so-called golden parachute if she left the company because of "conviction of a felony or willful gross misconduct." The filing is silent on the issue of what happens to that payment if she leaves under the cloud of indictment.

MacKay advises investors to avoid the stock and said it is worth about $7 a share based on all the information currently available. Other observers are equally skeptical.

"I don't think much of the company on a fundamental basis," said Mark Haefele, chief financial officer and chief operating officer of Sonic Capital and a contributor to RealMoney.com. Sonic is short Martha Stewart Living.

"It faces a variety of issues including poor corporate governance, no profits, poor prospects and shareholder lawsuits. Given these issues, this stock's run-up from its lows is emblematic of the speculative run we have had."

Martha Stewart Living is up 78% since hitting a low of $5.26 last October.

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Staff reporters Diane Hess and Stephen Schurr contributed to this account.