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Federated Probe Widens as SEC Targets Officers: Timing, Late-Trading Woes Impede Fund Sales


Federated Investors announced last week that it is engaged in talks with state and federal regulators to resolve previously reported trading abuses at its fund unit and that two of its officers could face enforcement actions.

The Securities and Exchange Commission and New York Attorney General Eliot Spitzer have not formally charged the company with any wrongdoing, but as the case unfolds it appears to be much more serious than originally anticipated.

In late 2003, the Pittsburgh-based mutual fund manager admitted that it had entered into several arrangements allowing hedge funds to market time six of its domestic equity funds and two of its high-yield bond funds in exchange for sticky assets that generated higher fees. The clandestine deals were not consistent with the trading guidelines outlined in the funds' prospectuses. Federated also said that an internal review revealed roughly 100 instances of late trading.

Federated, which manages $178 billion in assets, has not received the public flogging that some of the other big fund complexes have, but it has struggled to get new cash in the door. "It's certainly hurting them in terms of growing the business," said Matt Snowling, a senior equity analyst at Friedman, Billings, Ramsey in Arlington, Va. "The investigation has already had an impact on their bottom line, so it's in their best interest to get a quick resolution." Friedman does not have an investment banking relationship with Federated or any other conflicts of interest.

To its credit, Federated has managed to avoid bleeding assets at an alarming rate, unlike some of the other big fund shops embroiled in the fund scandal. In fact, Federated long-term equity funds have tacked on $1.3 billion in the last 15 months, according to Financial Research Corp. of Boston. But excluding its two Kaufman funds, net flows are in the red. Its money market funds have lost a hefty $17.23 billion in assets, but much of that can be attributed to an historically low interest rate environment.

Some analysts have been critical of the way Federated has handled the investigation, arguing that it has downplayed the seriousness of the transgressions. "They've been trying to fly low under the radar," said Kerry O'Boyle, an analyst at Chicago-based fund tracker Morningstar. "We found them to be not very forthcoming and slow to divulge information. He added that the company's attitude since the scandal broke has been one of "no remorse or regret." Morningstar has urged investors to avoid sending new money to Federated.

Initially, the company told investors in October 2003 that it found evidence of improper trading but failed to disclose the identity of the affected funds until a month later. Federated then forced the resignations of two sales officers who brokered the deals with the hedge funds and fired another employee who attempted to delete e-mails connected with the investigation. Federated has said that the bulk of the timing was done through omnibus accounts, which made it difficult to detect. As for the late trading, the company has since launched a remedial training program to ensure its support staff adheres to trading policies and procedures.

In February 2004, the firm sanctioned two higher-ranking officers for their lack of oversight in the matter, not disclosing their identity. Meanwhile, Federated had been telling its clients that it's not a big deal and that the late trading and other problems involve only lower-level salespeople who were not properly trained and thus manipulated by timers. Federated Chief Executive J. Christopher Donohue has maintained that the senior officers did not do anything intentionally wrong, from an ethical standpoint. His resolve has led investors to believe Federated's behavior was much less egregious than the first few fund firms to be put through the wringer.

But the fact that the SEC is now mulling civil charges against the two officers paints a much different picture. "The less upfront they are about who these folks are, the more skeptical customers are going to be about doing business with them," Snowling said. O'Boyle further criticized the firm for failing to take swift enough action in implementing seemingly necessary reforms in the wake of the scandal, including fine-tuning the language in its prospectus that relates to frequent trading and imposing redemption fees to deter potential market timers.

A spokesman for Federated disputed the notion that the firm was not aggressively pursuing more stringent controls to curtail market timing. "They're wrong in both cases," said J.T. Tuskan. "We're rolling out new prospectus language on market timing [and] dealing with frequent trading." Funds that have a prospectus renewal date of Dec. 31 already reflect a revised market-timing policy, Tuskan noted, while the others will publish the amended version in a few months.