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News January 9, 2006 Issue

Michigan Adviser Fined $100K For Marking the Close

A small Michigan-based adviser has agreed to pay a $100,000 penalty to settle SEC charges that he fraudulently entered orders designed to "mark the close" in four closed-end funds.

By entering market buy orders within a few minutes of market close at quarter-end, alleged the SEC, Schultz Investment Advisors and its president, Scott Schultz, intended to artificially raise the closing price of the fundsí shares, thereby boosting the performance of Schultzís client accounts and the amount of advisory fees it could collect on those accounts.

Two factors made it possible, and profitable, for Schultz to mark the close. First, the funds themselves were thinly-traded, permitting Schultzís trades alone to influence the closing price of the stock. Second, 90 percent of Schultzís clientsí assets were invested in the four funds. As a result, any increase Schultz was able to obtain in the closing price would be applied across a significant portion of his asset base.

The SEC alleged that Schultz engaged in marking- the-close transactions at the end of the last trading day for every quarter between June 2002 and December 2003. In all, the SEC claimed, Schultz entered sixteen buy orders within approximately five minutes of market close at quarter end. The trades were significant, often constituting approximately one-third to one-half of the dayís trading volume in the stock, according to the SEC. Consequentially, the trades caused the fundsí shares to close at artificially higher prices.

"As a result of the improper marking-the-close trades," said the SEC, the adviser "benefited by collecting more management fees from enhanced performance results."

The SECís order provided several examples of Schultzís alleged marking-the-close transactions. For example, on September 30, 2003, Schultz placed a trade for 12,750 shares of one of the closed-end funds. However, the clearing firm used by Schultzís broker was not able to purchase all of the stock prior to market close. As a result, the closing price of the fundís shares was $14.98. The clearing firm went on to purchase additional shares in the after-market at $15.50. During a recorded phone conversation with the broker, Schultz said, "I need the last tape . . . itís important. I am at quarter end . . . the last trade has to show $15.50." "[T]he newspaper will show $14.98 . . . that costs me a lot of money . . . I bill on a quarterly basis."

In addition, the SEC alleged that Schultz misrepresented the investment objectives of his clientsí portfolios and as a result, his clients held assets that were very different from their chosen objectives. For example, Schultz promoted one portfolio, the World Growth portfolio, as a combination of domestic and foreign closed-end funds. However, the SEC alleged that the portfolio held an insignificant amount of foreign closed-end funds.

The SEC also claimed that Schultz failed to file Schedule 13Gs, which were required to be filed because he had beneficial ownership of more than five percent of two of the closed-end funds. Under Rule 13d-3(a), an adviser has beneficial ownership of an equity security if it has the right to direct the disposition of the shares.

In addition to the $100,000 penalty, Schultz agreed to disgorge $14,534; to abstain from any marketing of his advisory firm for one year; to retain an independent consultant to review the firmís trading on a quarterly basis to verify that compliance with the federal securities laws; and to mail a copy of the SECís order to each of his firmís existing clients and new clients obtained within the next two years. Schultz also was ordered to cease and desist from future violations.

"We made an offer of settlement and the order is a result of that," said Schultzís lawyer, Robert Schneider of Sadis & Goldberg. "We neither confirm or deny any allegations that were made."