United States: Chicago Court Hands Out Harsh Sentences For Hedge Fund Trade Secret Theft

United States of America v. Yihao Pu et al., Case No. 1:11-cr-00699 (N.D. Ill.)

Following earlier plea agreements, "Ben" Pu 1 ("Pu") and Sahil "Sonny" Uppal ("Uppal") were sentenced today for stealing trade secrets related to high-frequency trading platforms from Chicago-based hedge fund Citadel. In what could be compared to a James Bond espionage thriller, through the use of personal storage devices and secret shadow computers,2 Citadel's alpha data and term data were systematically looted from its servers. The high-stakes gamble ended badly for Pu and Uppal.

High-frequency trading ("HFT"), the practice of utilizing high-speed fiber optic connections and computer algorithms to make securities and commodities trades in fractions of a second, has been the focus of the Department of Justice, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. Through the use of mathematical and statistical modeling, relationships among alternative investment instruments and market activities are translated into complex algorithms and ultimately proprietary computer source code for HFT programs. Once the programs are deployed, they automatically execute trades that can move hundreds of millions of dollars in fractions of a second. Administrative investigations related to the perceived unfairness of HFT activities are ongoing in the financial industry and a priority among regulators.3

Pu and Uppal aimed to defraud their first employer, referred to in the indictment as "Company A," and Citadel of their trade secrets and other confidential information. For some time, they were able to successfully hide the fact that they had taken confidential source code and other proprietary tools from Company A. Citadel, however, maintained a robust internal security protocol. Pu and Uppal's illegal activities raised internal red flags at Citadel and the illegal scheme was quickly discovered.

Once Citadel's investigation was handed over to federal prosecutors, Pu and Uppal were aggressively pursued. Each defendant was charged with a slew of counts relating to criminal trade secret theft. Pu was charged with: 11 counts of wire fraud (18 U.S.C. § 1343), 10 counts of theft of trade secrets in violation of the Economic Espionage Act of 1996 (18 U.S.C. § 1832),4 three counts of unauthorized computer access (18 U.S.C. § 1030), and two counts of obstruction of justice (18 U.S.C. § 1519). Uppal was charged with six counts of wire fraud (18 U.S.C. § 1343) and one count of obstruction of justice (18 U.S.C. § 1519).

This is not to say that the victims were careless in protecting their proprietary information. Company A and Citadel both took extensive precautions to protect their trade secrets. For instance, Citadel5:

  1. Required employees, including the bad actors, to sign employment agreements prohibiting unauthorized access to source code and trade secrets;
  2. Utilized security mechanisms to prevent unauthorized access; and
  3. Employed technical mechanisms to detect unauthorized access to source code and trade secrets.

This morning, Pu and Uppal appeared before U.S. District Judge Charles Norgle, in the Northern District of Illinois, who delivered strict sentences. Pu was sentenced to 36 months in prison followed by three years of supervised release6; Uppal was sentenced to probation. In addition, Pu and Uppal are jointly and severally required to pay $759,649 in restitution.7 Citadel had also earlier brought a civil action against Pu and Uppal in the Circuit Court of Cook County. Although not a matter of public record, a monetary settlement was likely obtained.

In the wake of the 2007-2008 financial crisis, the United States government has amplified its power to regulate and enforce compliance in the financial industry, and HFTs face heightened scrutiny.8 Former CFTC Commissioner Bart Chilton branded HFT's "cheetahs" because of their lightning-fast ability to execute trades with sometimes lethal impact on market participants.9 At the same time, however, the federal government, e.g., the CFTC, SEC, and DOJ, is aware that algorithms are valuable assets in the financial industry and their misappropriation could result in significant market disruption. Accordingly, the government is cracking down on motivated computer whiz-kids who attempt to steal these valuable and potent trading tools. Every trader who is considering leaving his current trading firm should take notice that the theft of trading firm strategies and algorithms can lead not only to a private civil action, but also a criminal indictment.

Trading algorithms or "algos" can generate hundreds of millions of dollars in revenue for trading firms. They are considered today by many firms the most important asset on the balance sheet. Pu and Uppal's actions illustrate the difficulty hedge funds face in safeguarding these assets from highly skilled and determined bad actors. Trade secret laws, which once were commonly used as a tool to protect proprietary manufacturing processes, confidential business information, or a secret recipe for soda pop,10 are fast becoming the trading firm's most important weapon of choice to protect its assets. The courts and regulators are quickly coming to understand their importance to the financial industry. Firms should take advantage of this legal trend and identify their trade secret assets and implement serious internal and external protective measures.

Footnotes

[1] Pu worked as a quantitative engineer in the fund's high-frequency trading unit. He had access to predictive algorithms and trading signals.

[2] Pu's scheme included a sophisticated hack of the system with the use of an encrypted black box. Pu also scuttled hard drives that included stolen confidential data and had them dumped in Wilmette Sanitary Canal. Scuba divers later recovered the hard drives.

[3] Laurel White, "Senators Fret Over High-Frequency Commodity Trades," USA Today (May 14, 2014, 11:25 AM).

[4] A crucial issue was whether Pu's actions constituted a crime under the statutory language of the Economic Espionage Act ("EEA"), because the law states that the trade secret must be related to a "product that is produced for or placed in interstate or foreign commerce." The Court determined the EEA applies, noting that the superseding indictment did not "specify that only HFT systems . . ., and not the securities traded on international financial markets could satisfy the EEA's product requirement." US v. Pu, 2014 U.S. Dist. LEXIS 5644, at *12 (ND Ill, April 17, 2014).

[5] Citadel's highly effective trade secret protection protocol was cited at sentencing as effectively thwarting any material harm to the firm.

[6] The government sought 87 to 108 months of prison time for Pu and argued to the court that the theft of these trade secrets deserves serious deterrence. The government went on to contend that trade secret theft will not go unnoticed by the United States Attorney.

[7] The government dismissed all but one charge against Uppal for obstruction of justice.

[8] William Kane and Gillian Whittlesey, The Review of Securities & Commodities Regulation: An Analysis of Current Laws and Regulations Affecting the Securities and Futures Industries, Vol. 46 No. 21, December 4, 2013; William Kane and Gillian Whittlesey, President Obama Requests 30 Percent CFTC Budget Increase as Financial Regulator Plans to Step Up Enforcement, March 6, 2014.

[9] "Look, these cats have some true attributes and they shouldn't become an endangered species. At the same time, they are impacting markets in ways we barely understand, and it ain't all good all the time." Rock'n the Trouble Speech of CFTC Commissioner Bart Chilton, BakerHostetler Chicago Hedge Fund Conference, June 18, 2013.

[10] PepsiCo., Inc. v. Redmond, 54 F.3d 1262 (7th Cir. 1995).

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