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.


Curtains?
Messy year at Martha Stewart


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.

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