PROTECTING HIGH FREQUENCY TRADING COMPUTER CODE

The merits of high frequency trading has been debated in recent weeks. Some mentioned it in connection with the so-called “flash crash.” Others think that it may give some traders an unfair advantage and requires correction.

A less discussed aspect of high frequency trading is the secrecy of the computer code that drives it. Last Friday, a Manhattan jury considered the issue and found a former Goldman Sachs computer programmer guilty in connection with the theft of the computer code which drives these platforms. U.S. v. Aleynikov (S.D.N.Y.). In that case defendant, Sergey Aleynikov was found guilty of one count of theft of trade secrets and one count of transportation of stolen property.

According to the court papers, Mr. Aleynikov was employed by Goldman from May 2007 through June 2009. Goldman has been improving and developing its high frequency trading system since 1999 when it first acquired the system in the acquisition of Hull Trading Company. Since that time, Goldman has continued to modify and improve the system. As part of its evolution, the firm took significant steps to protect the secrecy of the system.

Mr. Aleynikov was responsible during his tenure with the firm for developing computer programs supporting Goldman’s high-frequency trading on various commodities and equities markets. In April 2009, Mr. Aleynikov resigned from the firm to accept a position with Chicago-based Teza Technologies. He was hired to develop a high frequency trading platform for Teza.

Prior to his departure from Goldman, Mr. Aleynikov transferred substantial portions of the firm’s proprietary computer code for its high frequency trading platform to an outside computer server in Germany. The files were encrypted. After the transfer, he took steps to conceal the fact that he had transferred the files. This was not the first time Mr. Aleynikov took proprietary computer information from Goldman. During his employment he transferred thousands of computer code files.

Mr. Aleynikov is the second person conviction in recent weeks for stealing high frequency computer code. In November, another jury in Manhattan convicted Samarth Agrawal of the theft of trade secrets and the interstate transportation of stolen property from Societe Generale (here). Indeed, Mr. Agrawal seems to have been something of a trailblazer for Mr. Aleynikov. In the earlier case, the former SocGen trader stole the high frequency trading code to build a platform for a new employer – just as the jury last week concluded Mr. Aleynikov did. While the profits from these trading systems are significant – and knowledge of how to build them seems to help in the job market – perhaps two prosecutions and two convictions in as many months will help protect the secrecy of the systems by warding off would-be job seekers.

PARALLEL FINANCIAL FRAUD ACTIONS

The Manhattan U.S. Attorney’s Office and the SEC continue to bring cases in tandem. This time however, it is not insider trading, but financial fraud involving Vitesse Semiconductor Corporation, a California based integrated circuit maker and four of its former executives. U.S. v. Tomasetta, Case No. 10 CRIM 1205 (S.D.N.Y. Dec 10, 2010); SEC v. Vitesse Semiconductor Corporation, Case No. 10 CIV 9239 (S.D.N.Y. Filed Dec. 10, 2010); see also Litig. Rel. 21769 (Dec. 10, 2010).

The individuals named as defendants were the former CEO, Louis Tomasetta, the former Executive Vice President, Eugene Hovanec, the former Director of Accounting, Nicole Kaplan, and the former CFO, Yatin Mody. The SEC’s complaint also names the company as a defendant.

According to the court papers, two overlapping fraudulent schemes took place at the company which improperly inflated its revenues. One involved channel stuffing, while the other centered on backdated stock options.

The first began in about 2001 and continued through May 2006. It involved Messrs. Tomasetta, Hovanec and Mody, as well as Ms. Kaplan. This scheme began when the defendants realized the company would not meet its revenue or earnings targets. Revenue was improperly recognized on shipments of product to a distributor. On those shipments, there were side agreements which permitted the return of large portions of the product. At the same time, the company did not make adequate provision in its books and records to account for those returns as required. Although the company represented in its SEC filings that it did not recognize revenue on this basis, in fact it did so on large quarter-end transactions with a distributor. The amounts ranged from 15% to 41% of the company’s reported quarterly revenues during the period. The company also failed to properly record the credits from the returns.

The second scheme also began in 2001. It continued through 2004 and involved the backdating of options by Messrs. Tomasetta and Hovanec. The two defendants are alleged to have backdated options and then falsified the public filings of the company.

In April 2006, the company began an internal investigation regarding its option pricing practices. That investigation was later expanded to cover the revenue recognition issues. When this was publicly announced, the share price of the company fell by 28%.

Mr. Mody and Ms. Kaplan settled all outstanding charges. Each pleaded guilty to an information charging securities fraud, making false entries in the financial records of a corporation and conspiracy. Each is awaiting sentencing. With the SEC, Mr. Mody and Ms. Kaplan settled by consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). In addition, Mr. Mody agreed to pay disgorgement of $105,604, along with prejudgment interest. Ms. Kaplan agreed to pay disgorgement of $31,050, along with prejudgment interest. Each also consented to the entry of an order under Rule 102(e) suspending each from practice before the Commission as an accountant. The court will determine if either defendant should pay a civil penalty.

The company also settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a). It also agreed to pay a civil penalty of $3 million.

Messrs. Tomasetta and Hovanec have not settled. The indictment charges each with securities fraud, making false entries in the books and records of a corporation, making false filings with the SEC and conspiracy. Mr. Tomasetta was also charged with making a false certification of a financial report and making false statements to auditors.

The SEC’s complaint charges each with violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(b)(5) and 16(a) and the pertinent rules thereunder. In addition, Mr. Tomasetta is alleged to have violated Exchange Act Section 14(a). Each is also alleged to have aided and abetted violations by the company of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). Both the criminal action and the civil case are in litigation.