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.
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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
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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
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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
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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
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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
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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.
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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.
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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
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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.
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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).
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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).
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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
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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.