Professor Bainbridge has posted a response to questions I (and others) had emailed him regarding potential liability for Viacom under Rule 10b-5 for CBS's failure to come clean on Rathergate. I have nothing but respect for the good professor, but my take is Rather different. So--with the caveat that Professor Bainbridge teaches this stuff whereas I can barely remember my Securities Law class at Georgetown--let me offer this response.

1. I can't see how you show that the fraud (assuming there was one) was not "in connection with" the purchase or sale of a security. Even with the rather liberal touch and concern standard the Supreme Court has adopted to determine when a misstatement is made in connection with the purchase or sale of a security, there still must be some link between the two. I am unaware of any precedent in which the link between the alleged misstatement and the purchase or sale of a company's stock was this tenuous.

With its continuing assertions that the memos it reported last week are accurate, CBS is making a material statement as to the nature of its product (information), to wit: that it is accurate. I can think of few things that more closely touch and concern the sale of the stock of a corporation than a description of that corporation's product. Were General Motors to issue a statement to the effect that it had invented a car that ran on perpetual motion, said statement would surely meet this prong.

2. The speaker must have acted with scienter. It would have to be proven that Rather was reckless. if it turns out that his source was at least semi-reputable, that's going to be hard to do. Especially if the current take on the whole story - the documents are fake, but the basic gist is true - is supported.

I agree that it would be difficult to show scienter as to the original broadcast, but CBS has not stopped making statements. Now that a mountain of evidence as to the documents' falsity is available, CBS is at least reckless in continuing to state that they are genuine.

3. How do you show but for causation, even using the fraud on the market theory? What shareholder sold because he believed Rather (selling because you didn't believe Rather obviously doesn't count, because you were not misled).

I don't see why the analysis must be so narrow. CBS News is a significant business unit of Viacom. Its value lies in its ability to attract viewers and, as a result, advertisers. It attracts viewers in large part because it produces a quality (i.e. accurate) product. An investor assessing Viacom's value in the long term must surely evaluate whether it continues and will continue to produce that product. Dan Rather is saying that CBS continues to produce accurate news reports. That statement is false, and the market will surely incorporate the fact of the diminished value of CBS's product into Viacom's share price. Again, if GM announced tomorrow that it had invented a car that ran on perpetual motion, causation for a 10b-5 suit would surely be satisfied.

4. How do you show loss causation? You'd have to do an event study to show the extent of the damage caused by Rather's statements. The mere fact that the stock dropped in price roughly contemporaneously with the whole kerfuffle is nowhere near enough.

How do you ever show loss causation? You get a big pack of experts together to argue with Viacom's experts over what caused the drop (or gain). Meanwhile you've survived summary judgment and the lawyers' clocks are ticking.

5. It's got to be material. In other words, whether there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to act. In the totality of Viacom, a hit to CBS News likely is not material. CBS News could disappear tomorrow and the company's bottom line likely wouldn't change in a noticeable way (it probably would improve, but not so you'd notice).

Maybe so, maybe not. CBS is certainly among the most visible of Viacom's operations (and certainly the one most jurors will have heard of), so its value cannot be fully measured by reference to a balance sheet. Besides, I recall information as being material if there is a substantial likelihood that a reasonable investor would consider the information to be important or to have significantly altered the total mix of information made available about the investment. Basic v. Levinson, 485 U.S. 224, 231-32 & 235 n.13 (1988). "Significantly altering the total mix" strikes me as a pretty low hurdle to pass. Either way, it's a question of fact and therefore likely to be eventually decided by a jury. How confident do you think Viacom would be that a jury would find CBS's continuing bullshit immaterial?

I don't want to overstate the case--it surely isn't a slam dunk. But it has the advantage of (a) having enough meat on its bones that a lawyer who brought it wouldn't face sanctions, and (b) being certifiable as a class action, meaning that even small per share damages would mean enormous potential liability. Certainly smart trial lawyers like John Edwards have won big with less.

UPDATE: Bainbridge's major concerns seem to focus on two elements of a claim: materiality and causation (both transactional and loss causation). Let me say a few more words on each:

The standard test for materiality comes from TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), as applied to 10b-5 cases by Basic, Inc. v. Levinson, 485 U.S. 224 (1988). A fact is materal if there is a substantial likelihood that a reasonable shareholder would consider the fact of significance in determining how to act. Materiality does not require that knowledge or lack thereof would have caused the shareholder to act differently, only that it would have assumed actual significance in the mix of information the shareholder considered. While the law contains no precise numerical standard for when a fact becomes material, securities lawyer friends tell me that a fairly widely accepted rule of thumb is that information affecting 10% or more of an issuer of securities' assets, sales, or earnings is material while information affecting 5% or less is usually not (obviously there's a gray area between 5 and 10%).

A quick glance at Viacom's most recent 10-K shows that its television business (consisting of CBS and UPN) accounts for 29% of the company's 2003 consolidated revenues. I cannot imagine, therefore, how information that has the potential to do serious damage the CBS brand could not be material.

It should also be noted that Viacom cannot easily escape liability by couching its claims as "opinion." In Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991), the Supreme Court held that a statement by a company that its board "believes that $42 per share is a fair price" is an endorsement of the underlying fact (i.e. that the price is actually fair), not just a statement that a belief is genuinely held.

Finally on materiality, my guess is that the error in the initial report is not material. It was not a statement about Viacom's business and thus not substantially likely to be taken into account by a reasonable investor contemplating a purchase or sale of Viacom's stock. CBS's statements since then, however, (and especially Dan Rather's "I know that this story is true") amount to direct characterizations of CBS's product and business practices. Again, I can think of few things an investor would be more interested in when purchasing a company's stock than the nature of the company's products and business practices.

On loss causation: In order to prevail in a 10b-5 suit, a plaintiff must show that the defendant's misrepresentation was the cause of the plaintiff's loss. Where a large company like Viacom is concerned, determining exactly what causes share-price fluctuations can never be an exact science--there are simply too many factors acting on the market to be able to say with absolute certainty precisely what's behind any given share price fluctuation. But the standard of proof required in a 10b-5 suit (preponderance of the evidence) is much lower than absolute certainty. A plaintiff need only show that it is more likely than not that a misrepresentation caused a price change.

Consider the facts: On the day CBS first aired the story, Viacom's stock reached 35.20 per share. As forgery allegations swept the blogosphere, the stock dipped to 34.22--a nearly 3% loss--only to rebound to 35.25 on Friday in the wake of CBS's announcement that it continued to believe the memos were genuine. As the proof mounted and several major media sources have joined bloggers in declaring the memos fakes (and CBS in serious trouble), Viacom's share price has steadily trailed off, closing yesterday at 34.18--again, nearly 3% off its September 8 high. In a little less than a week, Viacom's shareholders lost nearly $2 billion in share value. Over the same period the SIG Cable Media Index, which tracks Viacom's market sector, climbed from 316.17 to 318.41 (despite the fact that Viacom is, itself, a component of the index). While Viacom's stock was tanking to the tune of $2 billion, its competitors stocks gained 1%. Share prices are largely driven by investor perceptions. The CBS scandal has been in the news every day since the 8th. Can you think of any other news concerning Viacom during the same period that might explain the slump?

On transactional causation (a.k.a. "reliance"): Where securities transactions take place (as almost all transactions involving Viacom stock do) through a major exchange (as opposed to between a face-to-face seller and buyer), courts usually apply the "fraud on the market" doctrine of transactional causation. Under this doctrine, it is supposed that investors rely "generally on the supposition that the market price is validly set and that no unsuspected manipulation has artificially inflated the price, and thus [rely] indirectly on the truth of the representations underlying the . . . price." Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert. denied, 429 U.S. 816 (1976). Hence, where the fraud on the market doctrine is applied, its effect is to create a presumption of reliance on any material misrepresentations. Basic, Inc. v. Levinson; see also, List v. Fashion Park, Inc., 340 F.2d 457 (2nd Cir. 1965) (When a fact is shown to be material, there is a strong indication that it was a substantial factor in causing the plaintiff to enter the transaction). If, as I argue above, CBS's misrepresentations are material, transactional causation is almost certainly satisfied (The only exception I can find is where a plaintiff knows the material misrepresentations to be false and invests anyway. Given CBS's repetition of its claims and its resort to various "experts" in defending them, I think showing that an investor "knew" the claims to be false would be a very tough slog.)

Now, I'll warn once again that I am not an expert in the area of Securities Law, so you should take that fact into account when weighing my disagreement with Prof. Bainbridge (who is one of the top guys in the field). But experts make mistakes, too--especially in mushy areas like whether or not a good trial lawyer could tag someone with a big civil suit. So with all due (and genuine) respect for Bainbridge's enormous expertise, I still disagree with his conclusion that there's no basis for a 105-b suit against Viacom.

UPDATE: CBS Ratings are way down and its affiliates are not happy. Material? You decide. (hat tip: Instapundit)

UPDATE: Sumner Redstone, the Chairman of Viacom, exercised options for shares worth about $12 million on Tuesday, netting a $6.7 million profit. This is the first time Redstone has ever exercised Viacom options. Mr. Redstone may wind up wishing he'd read Professor Bainbridge's post on insider trading before he made this move.