Rockies Fund, Inc. v. Securities & Exchange Commission

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 14, 2005 Decided November 15, 2005

No. 04-1255

THE ROCKIES FUND, INC., ET AL.,

PETITIONERS

v.

SECURITIES AND EXCHANGE COMMISSION,

RESPONDENT

Consolidated with

04-1259

On Petitions for Review of an Order of the

Securities and Exchange Commission

Edward J. Meehan argued the cause for petitioners The

Rockies Fund, Inc., et al. With him on the briefs was David E.

Carney.

David A. Zisser argued the cause and filed the briefs for

petitioner John C. Power.

Leslie E. Smith, Senior Litigation Counsel, Securities &

Exchange Commission, argued the cause for respondent. With

her on the brief were Giovanni P. Prezioso, General Counsel,

and Eric Summergrad, Deputy Solicitor.

2

Before: SENTELLE and RANDOLPH, Circuit Judges, and

WILLIAMS, Senior Circuit Judge.

Opinion for the Court filed by Circuit Judge SENTELLE.

SENTELLE, Circuit Judge: The Rockies Fund and directors

Stephen Calandrella, Charles Powell, and Clifford Thygesen

(collectively, “Rockies Fund petitioners”) along with John

Power petition for review of an order of the Securities and

Exchange Commission (“SEC” or “Commission”) sanctioning

them for various violations of Section 10(b) of the Securities

Exchange Act of 1934 and Rule 10b-5, among other provisions.

Calandrella petitions for review of an additional sanction for

violation of Section 57(k)(1) of the Investment Company Act of

1940. All petitioners argue that the SEC’s findings lack

substantial evidence. In addition, Rockies Fund petitioners ask

us to vacate the sanctions imposed by the SEC.

We agree with Rockies Fund petitioners and Power that the

SEC lacked substantial evidence for its finding of stock

manipulation under Section 10(b) and Rule 10b-5. We also

agree with petitioner Calandrella that the SEC lacked substantial

evidence for its finding of a Section 57(k)(1) violation. The

SEC’s findings of Section 10(b), Rule 10b-5, and other

violations for improper securities disclosures are supported by

substantial evidence. Accordingly, we grant the petition for

review, partially vacate the Commission’s order, and remand for

further proceedings.

I. Background

A. Factual Background

The events giving rise to this action occurred between 1993

and 1995. During that time, Stephen Calandrella, Charles

3

Powell, and Clifford Thygesen served as directors of the

Rockies Fund and as officers or directors of the Fund’s portfolio

companies. Registered as a business development company, see

15 U.S.C. § 80a-2(a)(48), the Rockies Fund was required to

manage its portfolio companies.

Prior to this period, petitioner John Power, his brother

Mark, and Raymond Stanz ran a line of “faux” jewelry stores

called Mirage Concepts. In 1993, Power sought to expand

Mirage by acquiring the assets of a bankrupt competitor. To

raise the needed capital, Power collaborated with his friend

Calandrella. They used one of Calandrella’s companies, a shell

corporation called Silver State Casinos, as an acquisition

vehicle. They named the new endeavor Premier Concepts, Inc.,

and sought NASDAQ listing. Suffering early disappointments,

Premier did not achieve NASDAQ listing until 1997.

In February 1994, Premier conducted a private placement

of stock and warrants. The stock was initially priced at $1.00

per share. The Rockies Fund participated in Premier’s

acquisitions and purchased Premier shares in 1994 and 1995. In

March 1994, Stanz took control of Premier. Friends and

relatives purchased the bulk of shares, but the stock generated

little further interest. Despite the inactivity, Premier apparently

never attempted to foster market interest through solicitation.

Ranald Butchard, friend to both Power and Calandrella,

purchased 200,000 shares in Canada during the initial offering

pursuant to SEC Regulation S, which governs securities sales

made outside the United States. See 17 C.F.R. §§ 230.901-.905

(2005). Holding roughly twenty percent of the outstanding

shares, he became Premier’s largest investor. When Premier

failed to meet NASDAQ listing requirements, Butchard inquired

about selling his shares. Power and Calandrella agreed to find

purchasers for Butchard’s shares because of the stock’s thin

4

market.

Butchard subsequently sold 180,000 shares between June

and September 1994. Because he had purchased his stock under

Regulation S, his shares were restricted by Regulation S’s resale

provision and therefore not freely tradeable. Counsel advised

Butchard that he could not legally sell his shares unless he sold

publicly. The shares went first to Premier’s market-maker,

Hanifen Imhoff, and were then bought by associates of

Calandrella, Power, and Butchard. Purchasers included Nathan

Katz and Arthur Nacht, both of whom learned of Premier

through Callendrella. Katz made purchases of 25,000 shares on

June 15, 10,000 shares on June 30, and 10,500 shares on August

19. Calandrella lent Katz money for at least some of the

purchases. Nacht made a single purchase of 10,000 shares on

August 30. Other purchasers included Power’s personal

companies, Power Curve and Redwood, and his brother, Brian

Power. Power Curve and Redwood each bought 25,000 shares

on June 15 and June 23, respectively. Brian Power bought 7,000

shares on June 17. Power also arranged for a business associate,

under the name Neon Rainbow, to purchase 10,000 shares on

June 17. Rounding out the trades, Butchard found a few buyers

himself.

John Power also owned a number of shares. Power engaged

in what he admitted to be “wash sales,” buying Premier stock

from, and/or selling it to, entities that he controlled, as well as

his brother Brian, with whom he apparently did not have an

arms-length relationship. Power testified that he undertook the

transactions (1) to take advantage of the settlement policies of

his Canadian broker, which allowed him, by way of trades

between his accounts, to receive de facto short-term loans from

that broker, apparently in the same way that a U.S. investor,

conducting a wash sale between a U.S. margin account and

some other account, receives a loan from the broker for the

5

margin account; and (2) to generate cash for himself or his

brother, depending on whoever needed it most at the moment.

On July 8, John Power purchased 5,000 shares from his brother

and 14,000 shares from Power Curve. He then sold 17,000

shares back to Power Curve on July 25. Power Curve sold

14,000 shares to Brian Power on August 17. Brian then sold

14,500 shares to his brother John on August 25. Brian Power

made a further 1,500 share sale to Power Curve on September

19. Finally, on October 21, John Power sold 4,250 shares, 2,500

to his own IRA account and 1,750 to his minor child.

Over the bulk of Butchard’s trades in June 1994, Premier’s

price fluctuated from $1.00 to $1.25. Power’s trades from July

until October, combined with Butchard’s remaining August

trades, took place during a period of consistent price increases

for Premier stock. From $1.25 in June, the stock rose to $2.50

by October 21. A few months after the last of Power’s trades,

the price had returned to $1.00 per share.

The Rockies Fund also took part in Premier’s initial

offering. It held over 100,000 shares of restricted Premier stock

and an additional 750 unrestricted shares. See 17 C.F.R.

§ 230.144(a)(3) (2005) (defining restricted securities). The

restrictions limited the Fund’s ability to trade the shares, which

accounted for between ten and forty percent of Fund assets. In

six quarterly reports to the SEC, though, the Fund incorrectly

listed all of its Premier shares as unrestricted.

In the same quarterly filings, the Fund used the quoted

market price for unrestricted shares as the value for its Premier

holdings. That method did not comport with the methods listed

in its 1983 prospectus, which required the Fund to discount

restricted shares from the unrestricted market price. Generally

accepted accounting practice also called for discounting

restricted stock. Under methods approved by outside counsel

6

Clifford Neuman, however, the Fund did not discount its

restricted shares.

The Fund claimed an additional 200,000 Premier shares in

its SEC filing of September 30, 1995. The purchase stemmed

from an oral agreement negotiated by Power. The Fund’s board,

however, did not approve the purchase until November 15,

1995, or pay for the shares until December 1995.

The Fund’s involvement with Premier extended beyond

share ownership and into management. During Premier’s

nascent stages, Power and Calandrella had a managerial dispute,

which resulted in Power’s withdrawal from Premier and Stanz’s

replacement by one of Calandrella’s associates. After Stanz was

removed as head of Premier, he threatened to sue both the Fund

and Calandrella. Under the provisions of a settlement

agreement, the Fund agreed to buy Stanz’s 85,000 shares for

$85,000. In addition, the Fund, Stanz, and Calandrella all

signed a mutual release from liability for events surrounding

Premier’s acquisitions. Calandrella signed the mutual release

without discussing it with other Fund directors.

B. Procedural Background

The SEC instituted administrative proceedings against

petitioners under Section 10(b) of the Securities Exchange Act

of 1934, Rule 10b-5, and other provisions. Following an

evidentiary hearing, the ALJ’s initial decision found that Power

and Calandrella had violated Section 10(b) and Rule 10b-5 by

manipulating Premier’s stock through matched orders and wash

sales. The ALJ also found that the Fund had violated Section

10(b) and Rule 10b-5, as well as Section 13(a) and Rules 12b-

20, 13a-1, and 13a-13, by misclassifying, overvaluing, and

misrepresenting ownership of Premier stock in quarterly SEC

filings. Further, the ALJ found Calandrella in violation of

7

Section 57(k)(1) of the Investment Company Act and Rule 10b-

5 for improperly accepting compensation and not reporting the

consequent conflict of interest to the board.

The ALJ imposed sanctions of $500,000 on Calandrella and

$160,000 each on Powell and Thygesen. The ALJ further

imposed a cease and desist order against all petitioners. Finally,

the ALJ permanently barred Calandrella and temporarily barred

Powell and Thygesen from associating with an investment

company.

The SEC conducted a de novo review of the ALJ’s decision.

Its opinion affirmed the ALJ’s ruling. All petitioners sought

reconsideration, but the SEC denied the request. The Fund and

Power now petition this Court for review of the SEC’s opinion

and its order denying reconsideration. See 15 U.S.C. §§

78y(a)(1), 80a-42.

II. Standard of Review

“The findings of the Commission as to the facts, if

supported by substantial evidence, are conclusive.” 15 U.S.C.

§ 78y(a)(4); see also Graham v. SEC, 222 F.3d 994, 999 (D.C.

Cir. 2000). A reviewing court may, however, set aside the

SEC’s conclusions of law if “arbitrary, capricious, an abuse of

discretion, or otherwise not in accordance with law.” 5 U.S.C.

§ 706(2)(A); Graham, 222 F.3d at 999-1000.

III. Substantive Violations

A. Stock Manipulation

In the context of securities transactions, Section 10(b)

prohibits the use of “manipulative or deceptive device[s] or

contrivance[s] in contravention of” the SEC’s rules, including

8

Rule 10b-5. 15 U.S.C. § 78j(b). Rule 10b-5 prohibits the use of

fraudulent devices in securities transactions. 17 C.F.R.

§ 240.10b-5(a). Matched orders and wash sales, both of which

the SEC found here, may constitute violations under Section

10(b) and Rule 10b-5. A matched order is a securities purchase

or sale entered with the knowledge that a reciprocal order of

substantially the same amount would be entered at substantially

the same time for substantially the same price. Ernst & Ernst v.

Hochfelder, 425 U.S. 185, 205 n.25 (1976). “Wash sales are

transactions involving no change in beneficial ownership.” Id.

(internal quotations omitted).

Nearly all of Butchard’s sales fit the definition of matched

orders: Buyers recruited by Calandrella and Power purchased

in quantities and at times that corresponded with Butchard’s

sales. Not having changed the shares’ beneficial ownership,

Power’s trades among his own companies likewise meet the

definition of wash sales. Neither Calandrella nor Power disputes

these SEC findings. Calandrella quibbles with the SEC’s

characterization of his participation in the Katz and Nacht

trades, but at root he does admit to his involvement with the

trades. Power admits that he participated in both matched orders

and wash sales.

But neither of these devices alone constitutes a securities

violation. Section 10(b) (and, accordingly, Rule 10b-5) also

requires a showing of intent and materiality. The parties

disagree about what standard of intent applies under Rule 10b-5.

Petitioners argue for a specific intent standard, but the SEC

contends that recklessness should suffice. Petitioners point to

Section 9(a)(1) of the 1934 Act, which expressly outlaws

matched orders or wash sales conducted “[f]or the purpose of

creating a false or misleading appearance of active trading” of

a registered security on a national exchange. 15 U.S.C.

§ 78i(a)(1). They argue that a lower standard of intent under

9

Rule 10b-5 would undermine Section 9(a)(1)’s specific intent

standard.

Whereas Section 9(a)(1) requires a showing of specific

intent, Rule 10b-5 generally requires only “extreme

recklessness.” SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir.

1992). Extreme recklessness is an “extreme departure from the

standards of ordinary care, . . . which presents a danger of

misleading buyers or sellers that is either known to the

defendant or is so obvious that the actor must have been aware

of it.” Id. at 642 (internal quotations omitted) (alteration in

original). In other words, extreme recklessness requires a

stronger showing than simple recklessness but does not rise to

the level of specific intent. The difference between the

standards could potentially have significant effects on the

interplay between Section 10(b) and Section 9(a)(1) and SEC

actions under each provision. Because we conclude that the

SEC has not met its burden of proving scienter under either

standard, we need not reach the question of what standard of

intent should be applied to matched orders and wash sales under

Section 10(b) and Rule 10b-5.

Treating each set of trades separately, we first look at

Butchard’s matched orders. After deciding to dump his Premier

stock, Butchard conducted all of his sales in the public market

based on the advice of counsel. The SEC questioned the need

for public sales, though, suggesting Butchard could have

avoided transaction costs by selling privately. The SEC noted

that a public sale signals market activity to investors. It

concluded that, in the absence of a transaction costs benefit, the

only purpose for publicly reporting the sales would have been to

create an appearance of market activity. On this reasoning, the

SEC found that Power and Calandrella intended to manipulate

the market.

10

Petitioners Calandrella and Power each dispute the SEC’s

conclusion and proffer alternative explanations for their actions.

They contend that securities laws forced Butchard to sell

publicly. At the very least, they say, Butchard’s counsel advised

him that, if he wanted to sell the stock, he could only do so in

this fashion. Furthermore, they argue that a private sale would

have incurred more transaction costs than a public sale.

We conclude that the SEC’s findings are unsupported by the

record evidence. The record shows that Butchard chose to sell

his shares on the public market for reasons wholly independent

of Calandrella and Power. The SEC made no finding that

petitioners induced him to sell initially; neither did it find that

they later coerced him into selling publicly. Indeed, other

evidence suggests SEC rules required the trades to be made

publicly. Testimony before the ALJ shows that Butchard’s

counsel advised him that he could not legally sell his shares

privately because of their Regulation S restrictions. Although

the SEC’s brief suggests Butchard need not have publicly sold

his shares, counsel at oral argument all but admitted otherwise.

Having virtually conceded that Butchard’s trades needed to be

public, the SEC has essentially abandoned the main evidentiary

leg propping up its findings.

Without evidence that Calandrella and Power induced

Butchard’s sales, some other evidence must exist to uphold the

SEC’s decision. The SEC suggests that Calandrella and Power

colluded in arranging Butchard’s sales, hinting that the alleged

collusion included price setting. Although collusion is not

necessary for a finding of intent, it is probative. Both

Calandrella and Power challenge the SEC’s insinuation,

asserting that they did not collaborate at all on Butchard’s

trades, let alone on the prices of those trades. As support, they

point to their well-known feud over Premier’s management.

11

The SEC concluded—correctly—that a managerial rift

between the two would not have precluded the possibility of

cooperation in other areas. That conclusion, however, does not

provide any affirmative evidence of actual collusion and

certainly not evidence of collusion about something as specific

as setting Premier’s stock price. As its only evidence of

collaboration, the SEC points to two facts: a single piece of

testimony by Calandrella and the general pattern of Butchard’s

trades. The SEC reads far too much into Calandrella’s

testimony and explains far too little about the supposed trading

pattern.

During the hearing, Calandrella was asked if he contacted

Power or Hanifen Imhoff, the market-maker, about unexpected

trades of Premier stock. Calandrella responded that he did

inquire. He did not specify, however, that he talked to Power,

and he only referred to unfamiliar trades. Standing alone, this

vague colloquy does not establish any systematic collaboration

between the two men. And even if the evidence does establish

some level of cooperation between the two, it clearly does not

establish manipulative price setting.

With respect to Premier’s trading pattern, the SEC says very

little. With no explanation, it announces that a pattern exists and

that it suggests cooperation between Calandrella and Power. No

pattern is immediately apparent from the record, however. The

Commission’s conclusion requires an explanation; without it,

the SEC has acted arbitrarily and capriciously. See Jost v.

Surface Transp. Bd., 194 F.3d 79, 85 (D.C. Cir. 1999) (quoting

Dickson v. Sec’y of Def., 68 F.3d 1396, 1404 (D.C. Cir. 1995)).

The SEC cited other evidence for its finding. It argues

before this Court that sales like Butchard’s should have

depressed Premier’s share price: Large sales by the largest

shareholder of a thinly traded company with poor fundamentals

12

generally create downward pricing pressure. The SEC’s brief

concludes that Calandrella and Power therefore acted to buoy

Premier’s shares artificially by supplying buyers for Butchard’s

shares. Despite any merit the argument may have, the SEC has

made it before the wrong tribunal. If this conclusion formed

part of the SEC’s reasoning, then it should have appeared in the

SEC’s opinion. See America’s Cmty. Bankers v. FDIC, 200

F.3d 822, 835 (D.C. Cir. 2000) (“[P]ost hoc rationalizations

cannot support an affirmance of an agency decision based on an

otherwise invalid rationale.”).

Turning to Power’s wash sales and matched orders, the SEC

offers a few unrelated propositions that it believes establish a

pattern of intentional manipulation. In conclusory fashion, the

SEC suggests that Power’s cash-generating transactions could

not have been worth the transaction costs. It also links Brian

Power’s transaction costs with the supposed manipulative intent

of his brother. The SEC fails to articulate why the transaction

costs were too high, and it makes no findings as to what level of

costs would have made the trades unpalatable. Further, the SEC

emphasizes that, at the end of the series of wash sales, Brian

ended up with a large position in Premier stock, which the

agency considers inconsistent with Brian’s story that he suffered

cash-flow problems that, in turn, motivated his participation in

the wash sales. John testified, however, that the movement of

cash between himself and his brother was a “two-way street,” in

which money went to whoever needed it most. Thus, Brian’s

ultimate position in Premier stock is not inconsistent with the

brothers’ story, assuming that John had greater need of cash

when the sales ended. The SEC’s lack of explanation suggests

the SEC found intent based on the mere existence of wash sales

and matched orders. But the simple fact that a party has

conducted a matched order or wash sale (or a series of them)

does not establish manipulative intent of any kind.

13

The Commission asserts that a finding that petitioners acted

recklessly can satisfy the scienter requirement, but the

Commission does not appear to have made any factual findings

to support this. In the securities fraud context, extreme

recklessness is not a lesser-included form of specific intent. See

Howard v. SEC, 376 F.3d 1136, 1143 (D.C. Cir. 2004). The

Commission made no findings that petitioners’ actions were an

“extreme departure” from a relevant standard of care, or that

they would “so obvious[ly]” create a “danger of misleading

buyers or sellers” that they “must have been aware of [the

danger].” Steadman, 967 F.2d at 641.

Because the record conflicts with the SEC’s scienter

findings under any standard of intent, its finding of a Rule 10b-5

violation for manipulation is not supported by substantial

evidence.

B. SEC Disclosure

Under Rule 10b-5, it is unlawful for anyone, in connection

with a security transaction, “[t]o make any untrue statement of

a material fact or to omit to state a material fact necessary in

order to make the statements . . . not misleading . . . .” 17 C.F.R.

§ 240.10b-5(b). The Supreme Court has defined materiality

under Section 10(b) and Rule 10b-5 as “a substantial likelihood

that a reasonable shareholder would consider it important in

deciding how to vote.” Basic Inc. v. Levinson, 485 U.S. 224,

231-32 (1988) (internal quotation and citation omitted). The

Court further explained that if there is a substantial likelihood

that a reasonable investor would have viewed the misleading or

omitted fact as “significantly alter[ing] the total mix of

information,” it is material. Id. (internal quotation marks and

citation omitted).

14

The SEC found Rockies Fund petitioners in violation of

Section 10(b) and Rule 10b-5, as well as Section 13(a) and

Rules 12b-20, 13a-1, and 13a-13, for filing misleading quarterly

and yearly disclosures. Specifically, the SEC found three kinds

of violations—misclassification, overvaluation, and improperly

claimed ownership of Premier stock. According to the SEC,

Rockies Fund petitioners misclassified and overvalued Premier

stock in five quarterly filings in 1994 and 1995 and its 1994

yearly filing. Additionally, the SEC determined that the Fund

misreported ownership of 200,000 Premier shares in its

September 30, 1995, quarterly filing.

1. Misclassification

Rockies Fund petitioners admit that the Fund misclassified

its Premier holdings in several SEC filings. Those filings

incorrectly labeled the vast majority of the Fund’s shares of

Premier stock as unrestricted when only 750 were actually held

as unrestricted shares. The Fund should have listed the shares

as restricted in each filing; listed as unrestricted, the statements

qualify as “untrue” under Rule 10b-5.

The Fund petitioners do, however, challenge the materiality

of the misclassification. In its opinion, the SEC determined that

the misclassifications were material in two ways. First, the

misclassifications affected the value of the Premier

holdings—and, therefore, the Fund’s financial statements.

Second, the misclassifications caused the Fund’s holdings to

appear more liquid than they really were. In addition, Premier

occupied a large percentage of the Fund’s total assets,

magnifying the effect of any misinformation about Premier.

Under these circumstances, a reasonable investor certainly

would have viewed the misclassification as “significantly

alter[ing] the ‘total mix’ of information.” See Basic, Inc., 485

U.S. at 231-32 (citation omitted).

15

The Rockies Fund petitioners also argue that they lacked the

requisite intent under Rule 10b-5. The SEC found it

“implausible” that the Fund directors could have overlooked this

kind of error in six separate filings. The Fund weakly disputes

the SEC’s scienter determination, but the SEC’s opinion has

ample support. Premier represented a large part of the Fund’s

holdings—between ten and forty percent. An attentive director

would have rectified the error absent extreme abdication of

ordinary care. In addition to the simple misclassification, each

filing used valuation language only appropriate for unrestricted

shares. Therefore, substantial evidence supports the SEC’s

finding of reckless indifference and “extreme recklessness.”

2. Overvaluation

Examining the same quarterly filings, the SEC also found

that the Fund overvalued its Premier holdings. The SEC

centered its analysis on the Fund’s 1983 prospectus, the Fund’s

only public statement on valuation procedures. The prospectus

endorsed four methods of valuation, none of which the Fund

used to value Premier. Instead, the Fund settled on the “quoted

market price” as Premier’s value. The SEC found that,

unmoored from its prospectus, the Fund used an ad hoc process

that mainly consisted of rubber-stamping Calandrella’s

recommendations. The SEC concluded that the

prospectus—and good accounting practice—would have

directed a different approach: valuing restricted stock by

discounting the shares from the unrestricted market price.

According to the SEC, standard accounting practice

supports the prospectus’s methodology and regards it as

improper to value restricted stock at the unrestricted market

value. The SEC determined that discounting would have

resulted in an appreciably lower valuation. Petitioners offered

no evidence of a discernible reason for choosing market price as

16

the appropriate value. Accordingly, we find the SEC’s

overvaluation findings are supported by general accounting

practice and the Fund’s own prospectus.

The Fund counters that, even if it technically overvalued

Premier stock, the prospectus sheds no light on the materiality

of the valuation. Furthermore, it says the overvaluation, if any,

caused no actual harm. Materiality, however, does not require

a showing of actual harm to investors. Graham, 222 F.3d at

1001 n.15. The SEC supported its finding of materiality,

concluding that an overvaluation of the Fund’s largest asset

would have been significant information for potential Fund

investors. In addition, as the Fund’s only public statement about

valuation, the prospectus does contribute to the overvaluation’s

materiality. Because the Fund rejected its publicly stated

valuation procedures and did not discount its largest holding,

substantial evidence supports the SEC’s finding.

Citing the Fund’s inconsistent and slipshod valuation

methodology, the SEC found a reckless disregard for the

accuracy of Premier’s stock valuations. The Fund disputes the

finding, claiming reliance on counsel for procedures adopted in

1994. But even if true, much of the testimony showed that the

Fund used no set procedure—whether developed by counsel or

not—for valuing its holdings, instead generally relying on

Calandrella’s recommendation to the board. Such a haphazard

process for valuing the largest holding of the Fund constitutes an

“extreme departure from the standards of ordinary care” that

should have been obvious to all the Fund’s directors. See

Steadman, 967 F.2d at 641-42.

3. Ownership

The SEC found that the Fund falsely claimed ownership of

an additional 200,000 Premier shares in its September 1995

17

filing. Rockies Fund petitioners claim that the Fund had made

a valid oral agreement for the shares in time for its September

1995 quarterly report. The SEC found otherwise, concluding

that the oral agreement lacked two essential elements, price and

amount, required by Colorado contracts law.

The parties dispute the meaning of the relevant statute. For

securities transactions, Colorado law at the time required a

writing “sufficient to indicate that a contract has been made for

sale of a stated quantity of described securities at a defined or

stated price.” Colo. Rev. Stat. Ann. § 4-8-319(a) (West 1995)

(repealed 1996). This provision requires the contract to have a

defined quantity and price, but the Fund asserts that the amount

and price need not be set until the time of the writing. The

contract, however, is the oral agreement, not the writing. The

oral contract itself must have the defined quantity and price in

order to be valid. Therefore, the Fund did not establish

ownership until its directors approved the purchase amount and

price in November 1995, well after the September filing.

The 200,000 shares comprised 46% of the Fund’s Premier

holdings and 11% of its total securities holdings. The SEC

substantiated its finding that the ownership error was material

based on the magnitude of the impact such a purchase would

have on the Fund.

The SEC also found the requisite scienter. Calandrella, as

agent, personally participated in the negotiations and knew the

status of the purchase agreement. When he approved the

quarterly report and its associated misrepresentation, he acted

with at least extreme recklessness. Accordingly, substantial

evidence supports the SEC’s finding of a Section 10(b) and Rule

10b-5 violation.

18

C. Release and Compensation

For business development companies, Section 57(k)(1) of

the Investment Company Act of 1940 makes it unlawful for any

“agent[] to accept from any source any compensation (other than

a regular salary or wages . . .) for the purchase or sale of any

property” on behalf of his employer, “except in the course of

such person’s business as an underwriter or broker.” 15 U.S.C.

§ 80a-56(k)(1). The SEC found that Calandrella violated this

provision by accepting the release of Stanz’s legal claims as

compensation in return for the Fund’s purchase of Stanz’s stock

interest in Premier. The SEC also found Calandrella in violation

of Rule 10b-5 for not reporting the release to the Rockies Fund’s

board of directors.

The SEC dismissed Calandrella’s claims that the release

was worthless to him. It concluded that the waiver benefited

Calandrella by ensuring that he would not be liable to Stanz.

Though not disputing that Stanz’s legal claims lacked merit, the

SEC stated that no lawsuit’s outcome can be infallibly predicted.

The Fund’s outside counsel, however, testified that he examined

Stanz’s potential claims and found them meritless.

Unquestionably, some legal claims are facially hollow. To

fulfill its evidentiary obligations, the SEC must do more than

globally declare that even frivolous lawsuits might succeed. The

SEC’s findings must be specific to the issue before it—does this

particular release have value? The SEC made no specific

findings as to Stanz’s claim yet paid no heed to the Fund’s

evidence. The SEC’s generalizations, not drawn from the

record, do not constitute substantial evidence for the SEC’s

finding that the release had value for Calandrella.

Having determined that the SEC’s finding of a Section

57(k)(1) violation lacks substantial evidence, we also decide that

19

the corresponding Section 10(b) and Rule10b-5 violations lack

substantial evidence. Those findings stem entirely from the

determination that the waiver was compensation and

accordingly are unsupported.

IV. Sanctions

Having found violations, the SEC levied sanctions against

the Rockies Fund petitioners and on petitioner Power. The SEC

imposed cease and desist orders on each individual petitioner.

It also imposed monetary sanctions on petitioners Calandrella,

Thygesen, and Powell, but not petitioner Power. Calandrella

received a penalty of $500,000. Thygesen and Powell each

received a penalty of $160,000.

The monetary sanctions imposed by the SEC amount to the

harshest available—third-tier sanctions. To impose third-tier

sanctions, the SEC must show that the violations “involved

fraud, deceit, manipulation, or deliberate or reckless disregard

of a regulatory requirement” and “directly or indirectly resulted

in substantial losses or created a significant risk of substantial

losses to other persons or resulted in substantial pecuniary gain

to the person who committed the” violations. 15 U.S.C. § 80a-

9(d)(2)(c). The SEC found that this standard applied but did not

even cursorily explain either element. One could say the entire

opinion, charitably read, provides the analysis for the first prong.

As to the second prong, however, the SEC gives no explanation

of how petitioners’ conduct either resulted in or created a

significant risk of substantial loss to others. Neither does it give

support for a finding of pecuniary gain. In sum, the SEC’s

analysis was not just superficial; it was nonexistent.

Accordingly, because the SEC did not explain its reasoning, we

hold that the SEC arbitrarily and capriciously imposed third-tier

sanctions on the petitioners. See Jost v. Surface Transp. Bd.,

194 F.3d 79, 85 (D.C. Cir. 1999) (quoting Dickson v. Sec’y of

20

Def., 68 F.3d 1396, 1404 (D.C. Cir. 1995)). We vacate the

sanctions and remand to the agency for further proceedings.

V. Conclusion

For the foregoing reasons, we grant the petition for review,

partially vacate the Commission’s order, and remand for further

proceedings not inconsistent with this opinion.