NEW YORK — Is Martha Stewart a liar, who defrauded shareholders in her company to prevent its stock from plummeting?

That's what federal prosecutors argue, and if they can convince a jury, the next space the domestic diva decorates may be a jail cell.

Stewart, 62, is charged with conspiracy, obstruction, lying to investigators and securities fraud in connection with the sale of her stock in ImClone, a biotech company, and public comments she made regarding the federal investigation into that sale.

Standing trial alongside Stewart is her former stock broker, 41-year-old Peter Bacanovic, who is also charged with conspiracy, lying to investigators, and obstruction, in addition to allegations of falsifying documents and perjury.

After news broke of the investigation in June 6, 2002, and filled headlines across the country, Stewart was confronted about it point-blank during her regular weekly appearance on CBS's Early Show. Host Jane Clayson asked her about the probe, while the homemaking icon was showing viewers how to prepare a salad.

"I will be exonerated of any ridiculousness," Stewart said. When pressed further, she snapped, "I want to focus on my salad because that's why we're here."

Stewart's troubles stem from her sale of 3,928 shares of ImClone on Dec. 27, 2001, one day before the FDA announced it had rejected the application for approval of ImClone's cancer drug, Erbitux — news that sent the company's stock prices tumbling.

Though she profited $51,000 by selling in advance of the announcement, Stewart was never charged with insider trading. But ImClone's CEO Sam Waksal was. He and his family dumped all their shares in the company prior to the negative news, netting $7.3 million.

Former ImClone CEO Samuel Waksal is serving an 87-month sentence for insider trading.

Waksal's blatant sell-off triggered a massive SEC investigation, which looked into other shareholders who sold ImClone days before it tumbled. Martha Stewart, one of the most successful women in the country, and a personal friend of Sam Waksal, was on the top of the list.

It was Stewart's response to this federal probe that landed her in hot water. Prosecutors claim she not only conspired with Bacanovic to cover-up evidence concerning the sale, but also lied publicly about her involvement in the scandal to protect the stock price of her own company, Martha Stewart Omnimedia.

The Investigation

Though investigators found no evidence that Stewart was tipped off by Waksal himself, they grilled Stewart's broker, Peter Bacanovic, and his assistant, Douglas Faneuil, both employees of Merrill Lynch.

Bacanovic, who is also Waksal's broker, claimed he and Stewart sold her ImClone stock pursuant to a "selling conversation" they had on Dec. 20, 2001, a week before the sale was executed.

Peter Bacanovic, Stewart's stock broker, will be tried alongside the homemaking icon.

During that conversation, Bacanovic said, he and Stewart reviewed her entire portfolio, not just her shares of ImClone, and agreed to sell her shares in the company if the price sunk to $60.

Stewart's story mirrored Bacanovic's when she was questioned shortly after his interview. She corroborated his claims that he never told Stewart about Waksal's sale, which would have been a breach of Merrill Lynch confidentiality policy, as well as insider trading laws. The two say he only called to inform her that the stock had dipped below $60.

According to prosecutors, however, the evidence tells a different story. They say that Bacanovic, who was vacationing in Miami at the time, received a call the morning of Dec. 27, 2001, from Faneuil informing him that Waksal and his family sought to dump all of their ImClone stock.

Bacanovic, in turn, left a message at Stewart's office, which was recorded in a message log by Stewart's assistant. It read, "Peter Bacanovic thinks ImClone is going to start trading downward."

Stewart called Merrill Lynch and spoke to Faneuil who tipped her off about the Waksal shares, according to prosecutors. She allegedly told him to sell, and the trade was executed at 1:52 p.m. At an average price of $58.43 a share, Stewart netted approximately $228,000.

In the midst of the investigation, Stewart was nominated to the board of directors of the New York Stock Exchange. But the probe had not yet become public knowledge.

Investigators ordered Merrill Lynch to turn over documents related to the case, including a worksheet prepared by Bacanovic regarding Stewart's holdings. Bacanovic claims the worksheet, bearing handwritten notations in blue ink, resulted from his selling discussion with Stewart. Next to the ImClone entry, there is a note that reads, "@60," which refers to the share price that would trigger a sale.

According to prosecutors, however, the blue ink used to write "@60" is "scientifically distinguishable" from the pen ink used on the rest of the worksheet.

In the Headlines

The investigation into Stewart became front page news when the House Energy and Commerce Committee, already investigating ImClone trading, announced it was probing Stewart's stock sale on June 6.

The next day, the Wall Street Journal broke news of the investigation and said Stewart's lawyers offered the same explanation they provided investigators: Stewart sold because the price fell below $60, a value predetermined by her and her broker.

Stewart issued several written statements maintaining her innocence, one of which she issued the same day Waksal was charged with insider trading.

Her supporters criticize the investigation, saying federal agents were unfairly targeting one of the richest women in the world, whose fortune is built on her reputation. She is a high-profile, success-obsessed entrepreneur, which makes her an attractive target for prosecutors, her supporters claim.

Federal authorities got another break in their case when Faneuil confessed he spoke to Stewart himself on Dec. 27. Faneuil said he was under orders from Bacanovic to pass along the confidential information regarding Waksal's sell-off. Moreover, he claimed Bacanovic gave him an extra week of vacation and an airline ticket in exchange for his silence.

Douglas Faneuil, Bacanovic's former assistant, could be the prosecution's star witness.

Faneuil cut a deal with prosecutors and pleaded guilty on Oct. 2, 2002, to one misdemeanor count in exchange for his testimony against his former boss and the homemaking icon.

The next day, Stewart resigned her post with the New York Stock Exchange. The price of stock in her company, Martha Stewart Living Omnimedia (MSO), took a huge hit after news broke of the investigation.

Hovering at around $19 per share in May, before news of the investigation was made public, the stock closed at $6.21 on Oct. 3, 2002, a drop of about 67% in four months.

Resignation

Eight months later, just when it MSO stock was beginning to rebound, Stewart and Bacanovic were indicted. After a 41-page, nine-count indictment was unsealed on June 4, 2003, Stewart resigned as CEO of her company.

Bacanovic and Stewart were each charged with one count of conspiracy and obstruction. Stewart was also charged with two counts of securities fraud and making false statements to investigators. Bacanovic was additionally charged with one count each of producing false documents, perjury and making false statements.

In the indictment, prosecutors claim that Stewart and Bacanovic conspired to cover up evidence that her sale of ImClone stock was based on inside information. They say the pair concocted a fictitious story about a conversation in which they agreed to sell the stock when it sunk to $60 a share — and that Stewart foisted that story on the public to avoid damage to her company.

Prosecutors also allege that Stewart lied about her conversation with Bacanovic the day of the trade, saying that she spoke to Faneuil, not Bacanovic, when giving authorization for the sale.

Stewart, pictured giving gardening tips.

Furthermore, they claim that Stewart changed wording in her phone log from "Peter Bacanovic thinks ImClone is going to start trading downward," to "Peter Bacanovic re imclone [sic]" but instructed her assistant to revert to the original phrasing before handing over her records to investigators.

In their fight to have the securities fraud charges dismissed, Stewart's lawyers cited the First Amendment, arguing that she had a right to protect her reputation.

U.S. District Judge Miriam Goldman Cedarbaum denied the motion to dismiss the charge, saying it was a question for the jury to decide whether Stewart's public statements were protect under the Constitution or constituted stock fraud.

Stewart faces a maximum of 30 years in prison, with each count carrying a five-year term, except the securities fraud charge, which is punishable by up to 10 years. Bacanovic faces a maximum of 25 years.

It's highly unlikely, however, that either defendant will serve that much time if convicted. Federal sentencing guidelines give flexibility for much shorter sentences.

Lawyers are expected to begin questioning prospective jurors on Jan. 20.