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Federated Might be Spitzer's Swan Song: Expert: Joint SEC Settlement Further Validates Probe


In what could mark a turning point in a 26-month-old scandal that has touched every corner of the money management industry, Federated Investors reached a $92 million settlement with state and Federal regulators last week over allegations that it allowed market timing and late trading in some of its mutual funds.

Officials with the Office of the New York Attorney General would not comment on the status of its ongoing investigation, which first broke in September 2003 with the takedown of the New Jersey hedge fund Canary Capital Partners, but judging from Eliot Spitzer's words, the race is much closer to its finish than its start.

"With this agreement," Spitzer said in a statement, "virtually the entire mutual fund industry has now sworn off improper trading practices and agreed to compensate investors who were harmed."

That's not to suggest that the heightened scrutiny and rulemaking from the Securities and Exchange Commission, which exacted a tidy share in the Federated payout, is anywhere near its conclusion. The Commission's vigorous legal defense of its controversial independent chairman rule, for example, is evidence enough that going forward, it won't tolerate the slightest hint of trading shenanigans.

"The SEC has a very long memory," said Ross A. Albert, a partner with the law firm Morris Manning & Martin in Atlanta and a former special counsel in the SEC's division of enforcement. "There's going to be enhanced scrutiny for many years. The people I've spoken with at the SEC have told me in so many words that they're not going to let something like this happen ever again."

Spitzer's investigation, meanwhile, is cooling off a bit, Albert said.

"Consistent with the way many politicians behave, he's made a big splash, and now it's time to move on to other things, including a run for governor. But the net result of his investigation has been positive for investors," Albert added.

Pittsburgh-based Federated, a $207 billion money manager, is the 14th firm Spitzer has settled improper mutual fund trading charges with since 2003. It also brings the amount of money returned to investors hurt by the scandal to approximately $3.3 billion and probably takes a bit of the sting off his office's debacle in its case against former Bank of America broker Theodore Sihpol III, who this past summer beat 33 counts of fraud. That hiccup aside, Spitzer has scored guilty pleas against nine mutual fund executives.

And for all the haranguing Spitzer has taken from the industry, judging from the words of Federated executives, his brand of muckraking has gone a long way toward changing the "assets at all costs" culture of many fund complexes. For instance, less than six months after it was hauled in front of the television cameras for trading abuses and far ahead of the SEC's new compliance measures, Federated basically sent its salespeople back to school to relearn trading regulations. Others were punished, and one person was fired.

"We have taken comprehensive action designed to prevent the identified lapses from recurring," said John E. Murray, Jr., chairman of Federated's independent directors, in a letter to shareholders announcing the settlement.

In a separate letter, Federated President and CEO J. Christopher Donahue said the settlement closed a difficult chapter in the firm's 50-year history and "has strengthened our resolve to deliver a culture of compliance to fund shareholders."

Court documents from the Attorney General and the SEC reveal that trading abuses within Federated funds dated back as far as 1998, as did language in various Federated fund prospectuses stating that the firm considered market timing detrimental to other shareholders and would terminate the availability of exchanges to shareholders suspected of the practice. Market timing is only illegal when a fund states in its prospectus that it isn't tolerated.

Ironically, during the late 1990s, Federated designated "timing police" to monitor frequent traders, and the group placed stops on several thousand accounts because of market timing. But at the same time, regulators claim, the company's investment management and broker/dealer unit entered into several arrangements to allow market timers to frequently trade in certain Federated funds.

Specifically, court papers show, senior officers at Federated Investment Management and Federated Securities approved a deal in 2003 that allowed Canary Capital to market time six domestic Federated funds. In exchange, Canary placed as much as $50 million in sticky assets in a Federated European fund. Ultimately, court records reveal, Canary was given permission to trade $50 million in two to three "roundtrips" per month in each of the six funds. Within 30 days, Canary was market timing more than $84 million in five funds.

By March, the Federated timing police discovered Canary's activity and placed stops on the accounts. Within days, the stops were lifted and the timing police were notified that Canary was essentially trading under executive privilege.