The Pittsburgh-based fund company reports that an investigation conducted by Cornerstone Research uncovered the following activities:
With regard to frequent trading, the review identified one client that appeared to have made one offsetting trade of approximately $125,000 that might have been prevented had the reports been reviewed on a timely basis. However, Federated said the review uncovered no arrangement permitting this one trade and no indication that other clients/accounts covered by the unreviewed internal trading reports did so.
Federated said the review found no evidence that the company or any of its employees had arranged with investors to accept after-hours trades. However, the review did find instances in which employees, as previously reported, incorrectly accepted fund orders that were placed after the funds’ closing times and received that day’s prices. Federated said it appeared that the orders received after the 4:00 p.m. close were “inadequately monitored and there was insufficient oversight to correct these errors.”
Still, Federated said that over the past five years the orders had no material impact, yet the firm has decided to reimburse the funds for any potential losses that might have resulted from the erroneous entry of trades after 4:00 p.m., and has included funds to cover that exposure in the reimbursement fund. Federated noted that “most trades in Federated mutual funds are handled by intermediaries, on which the Company, in accordance with industry practice, relies to accept orders.”
The review identified one employee who, between January 1999 and March 2003, regularly placed orders after the funds’ closing times, in amounts ranging from approximately $26,000 to less than $100. Federated has since terminated the individual’s employment.
The review also found that an employee in one instance incorrectly accepted orders for approximately $52,000 from a Company officer after the applicable funds’ closing times, though the officer has now paid the funds for the difference between the correct share prices and the prices used in processing the orders, and is being sanctioned by Federated.
The review also examined personal trading in Federated mutual funds, including trading in their 401(k) plan. While the review found no personal trading by portfolio managers that violated Federated’s Code of Ethics for Personal Trading, industry regulations or the Company’s 401(k) plan policies, the review did identify two portfolio managers who had personal trades in the Company 401(k) plan in funds that they managed.
According to Federated, one portfolio manager had two offsetting trades over a five-month period, with durations of 35 and 76 days in amounts of approximately $600,000. The other manager had seven offsetting trades in a 21-month period, with durations from nine to 62 days in amounts of up to $160,000. The Cornerstone review determined that these trades had no material detrimental impact on the funds, according to Federated – but the firm is sanctioning both individuals.
In response to the review's findings, Federated announced the following actions:
- Frequent trading: Federated said it is sanctioning two company officers who, under the belief that such trading would not be detrimental to the funds involved, permitted frequent trading by one hedge fund investor that was reported in Federated's November 25th press release .
- After-hours trading: The Company has increased oversight of orders processed after 4:00 p.m. to help ensure that no orders are incorrectly accepted after the funds' closing times.
- Employee trading: The Company has modified its Code of Ethics to require review of Federated mutual fund trading and establish minimum holding periods. Additionally, the firm now requires that its officers and investment personnel report to the compliance department all trades in Federated's fluctuating net asset value mutual funds, other than certain short-term fixed-income funds, and has put in place a new policy requiring company officers and investment personnel to hold personal investments in those funds for a minimum of 60 days.
- Federated has announced its intention to outsource its transfer agent functions to Boston Financial Data Services by June 30, 2004. Federated said the move will allow it to focus on its core business of investment management and mutual fund distribution.
Based on Cornerstone's findings, the Independent Trustees of the Federated mutual funds and the Company's Board have established a restoration fund of approximately $7.6 million. While the Independent Trustees have not yet determined how to distribute the restoration funds, and no government agency has passed on the establishment or amount of the restoration fund, Federated outlined the breakdown of the fund as follows:
- approximately $4.8 million related to the detrimental impact on the funds from frequent trading activity
- approximately $2 million related to the possible detrimental impact on the funds that may have resulted from orders incorrectly accepted by Federated employees after the funds' closing times
- fees of approximately $420,000 received from assets invested as a result of frequent trading arrangements
- approximately $355,000 of interest on these amounts.
Additionally, Federated says it has retained an independent expert, KPMG, to conduct a review of its internal audit and compliance functions and to recommend appropriate enhancements. KPMG will be reporting its findings and recommendations to the Chief Legal Officer and the Company's Audit Committee for review and implementation. The firm has also enhanced its compliance function by altering the reporting structure to provide a direct report by the head of compliance to the audit committee of the Federated funds, which is composed of Independent Directors.
Federated reported that its fourth quarter 2003 financial results will include a charge of approximately $7.6 million for the restoration fund and approximately $12.4 million for other expenses related to the review, including those of the funds, though that amount does not include fines, penalties or other amounts that may be sought by governmental agencies or through claims asserted in private litigation.