Thanks for the answer. I guess it's actually clear from the rule #2 of the official FAQ, I had just missed the that when it says the new satellites cannot be adjacent to your other satellites and planets, it specifically refers to the ones in existing federations, it's a big distinction as opposed to being next to any planet that's not meant to be part of the newly formed federation, which is how I had assumed it was meant to be. When reading it again now, it does make sense that the federation on the screenshot isn't legal.

What exactly made your federation illegal? Looking at the screenshot, I'm not able to identity the issue.