July 7 (Bloomberg) -- Goldman Sachs Group Inc. may lose its investment in a proprietary trading code and millions of dollars from increased competition if software allegedly stolen by a former employee gets into the wrong hands, a prosecutor said.

Sergey Aleynikov, an ex-Goldman Sachs computer programmer, was arrested July 3 after arriving at Liberty International Airport in Newark, New Jersey, U.S. officials said. Aleynikov, 39, who has dual American and Russian citizenship, is charged in a criminal complaint with stealing the trading software. Teza Technologies LLC, a Chicago-based firm co-founded by a former Citadel Investment Group LLC trader, said it suspended Aleynikov, who started there on July 2.

At a court appearance July 4 in Manhattan, Assistant U.S. Attorney Joseph Facciponti told a federal judge that Aleynikov’s alleged theft poses a risk to U.S. markets. Aleynikov transferred the code, which is worth millions of dollars, to a computer server in Germany, and others may have had access to it, Facciponti said, adding that New York-based Goldman Sachs may be harmed if the software is disseminated.

“The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways,” Facciponti said, according to a recording of the hearing made public yesterday. “The copy in Germany is still out there, and we at this time do not know who else has access to it.”

‘Preposterous’

The prosecutor added, “Once it is out there, anybody will be able to use this, and their market share will be adversely affected.”

The proprietary code lets the firm do “sophisticated, high- speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year.

Defense attorney Sabrina Shroff said in court that the government’s allegations are “preposterous.” The firm was aware that Aleynikov, who is the father of three young girls, was downloading programs to his personal computer to do work at home and that he hasn’t disseminated the code, the lawyer said.

“If Goldman Sachs cannot possibly protect this kind of proprietary information that the government wants you to think is worth the entire United States market, one has to question how they plan to accommodate every other breach,” she said.

Michael DuVally, a spokesman for Goldman Sachs in New York, declined to comment.

$750,000 Bail

U.S. Magistrate Judge Mark Fox ordered Aleynikov, who earned $400,000 a year, to be held by on $750,000 bail, after prosecutors claimed he posed a threat to the community. Aleynikov planned to earn three times his salary by joining a startup company and engaging in high-volume automated trading, prosecutors said. Aleynikov posted bail yesterday and was released.

Aleynikov didn’t speak at the hearing, except to say that he understood the conditions of his bail.

Teza, co-founded by former Citadel trader Misha Malyshev, said in an e-mailed statement that it first learned of the allegations on July 5 and suspended Aleynikov without pay following an investigation.

The firm “was not aware of the alleged misconduct” and offered to cooperate with the government, according to the statement.

Reverse Engineering

“Someone stealing that code is basically stealing the way that Goldman Sachs makes money in the equity marketplace,” said Larry Tabb, founder of TABB Group, a financial-market research and advisory firm. “The more sophisticated market makers -- and Goldman is one of them -- spend significant amounts of money developing software that’s extremely fast and can analyze different execution strategies so they can be the first one to make a decision.”

Someone could use the code “to implement the same strategies and maybe on certain stocks they can be faster and, in effect, take away money that would normally be Goldman’s,” Tabb said in a phone interview. “The second thing that they can do is actually analyze the code so that they know what Goldman’s going to do before Goldman does it and kind of reverse engineer Goldman’s strategies and make money basically at the expense of Goldman.”

‘Wake-Up Call’

Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission, said proprietary electronic data poses significant risks for all financial institutions.

“This is a wake-up call to all financial institutions to review their security systems, not just with respect to trading codes, but with respect to all proprietary information,” said Pitt, now chief executive officer of Kalorama Partners LLC in Washington.

Goldman appeared to have taken some steps to prevent the theft of its code, Pitt said. “The real question is whether, in light of this outrageous conduct on the part of one of its employees, it should have taken more steps,” Pitt said.

Aleynikov spent four hours with a Federal Bureau of Investigation agent after his July 3 arrest, Shroff said. He told the agent that he’d done nothing wrong, authorized prosecutors to seize his personal computers, and said he hadn’t known the server he was using was in Germany, she said.

32 Megabits

Only 32 of 1,024 megabits of the software code was transferred, Shroff said.

“It is not disseminated,” she said of the code.

Facciponti said at the hearing that Aleynikov could disseminate the code “in 10 minutes” using a cell phone. Once the government obtains access to the German server, prosecutors will see if Aleynikov transferred other confidential data as well, he said. It’s logical to conclude that Aleynikov planned to use the code at his new company, the prosecutor said.

“This is the most substantial theft that the bank can remember ever happening to it, in the sense the entire platform has been taken from it,” Facciponti said. “There has been no breaches anywhere on this magnitude at the bank.”

Aleynikov worked at Goldman from 2007 until June, the government said in the complaint. He was part of a team of workers responsible for improving the computer platform. His alleged transfer of computer codes ran from June 1 to June 5, according to prosecutors.

Moscow, Rutgers

Aleynikov studied applied mathematics at the Moscow Institute of Transportation Engineering before transferring to Rutgers University, where he received a bachelor’s degree in computer science in 1993 and a master’s of science degree, specializing in medical image processing and neural networks, in 1996, according to his profile on the social-networking site LinkedIn.

Before joining Goldman Sachs, he worked for about eight years at IDT Corp., the U.S. vendor of prepaid calling cards, where he led the team responsible for developing routing systems, according to the profile.

His profile on LinkedIn describes him as a vice president in equity strategy at Goldman Sachs and includes two recommendations from colleagues at the firm.

Goldman Profit

Goldman was the world’s biggest and most profitable securities firm until it converted to a bank in September following the bankruptcy of smaller rival Lehman Brothers Holdings Inc. Goldman earned $2.3 billion last year, down from a record $11.6 billion in 2007, as market turmoil caused it to report a fourth-quarter loss, its first in a decade as a public company.

Goldman’s equities business generated $2 billion of revenue in the first three months of 2009, down 20 percent from the first quarter of 2008, the company reported in April. Second-quarter results are due to be reported next week.

Goldman rose $2.97, or 2.1 percent, to $146.46 in New York Stock Exchange composite trading yesterday.

The case is U.S. v. Aleynikov, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporters on this story: David Glovin in New York federal court at dglovin@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.

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July 7 (Bloomberg) -- General Motors Corp.’s sale of most of its assets to a U.S. Treasury-funded buyer won’t be stalled by the only appeal of a decision approving the transaction, a lawyer for objecting creditors said.

Steven Jakubowski, a lawyer for creditors appealing a July 5 ruling, said he won’t seek a stay blocking the sale while the appeal is being considered. His clients are people with accident-related claims involving GM vehicles. Jakubowski said the new company should take responsibility for claims that predate the sale.

U.S. Bankruptcy Judge Robert Gerber, who approved the sale, said it was the only option available to the bankrupt Detroit- based automaker, which filed for court protection June 1. The appeal should go directly to a federal appeals court, Jakubowski said.

“This is a matter of public importance,” Jakubowski, an attorney with the Coleman Law Firm in Chicago, said in a phone interview on why he appealed yesterday.

Gerber stayed his order through noon New York time July 9 to give opponents a chance to appeal. GM asked that the order to be made effective immediately.

The Unofficial Committee of Family & Dissident GM Bondholders said in an e-mailed statement from their lawyer Michael Richman that it doesn’t plan to appeal the sale due to the potential cost.

Lack of Resources

“The committee members today simply lack the resources needed to mount an effective appeals process on the accelerated basis that would be required here,” chairman Hal John said. The group of three investors said they were representing as many as 2,000 others who own as much as $500 million of GM debt. Richman of Patton Boggs LLP had argued Gerber should call the Obama administration’s bluff that it would let GM liquidate if the sale weren’t approved. He wanted Gerber to force the automaker to file a complete reorganization plan on which creditors could vote.

GM’s lawyer Stephen Karotkin, of Weil, Gotshal & Manges LLP, said that barring a further stay the sale will “close promptly,” a comment repeated by GM Chief Executive Officer Fritz Henderson on a company blog.

The company will have a “leaner and meaner” management after the sale closes, said Steven Rattner, the Treasury’s chief auto adviser. The new GM will be a smaller company than it was and somewhat less global so it will be natural for the management structure to change, Rattner said yesterday during a conference call.

Executive Firings

GM has said it will fire about 35 percent of its top 1,300 executives, leaving it with 845.

Gerber’s decision largely followed the ruling of another Manhattan bankruptcy judge, Arthur Gonzalez, who approved the sale last month of most of the assets of GM’s smaller rival, Chrysler LLC, to an entity to be run by Fiat SpA. That decision was affirmed by the Second Circuit, though the court has yet to issue a full opinion.

“This is going to be a hard appeal to win, at least in the initial rounds,” Seton Hall University professor Stephen Lubben said, noting Jakubowski would need to get the case before the Second Circuit very quickly without a stay beyond July 9.

Gerber decided the GM sale, like Chrysler’s, could be done “free and clear of claims,” meaning the reorganized company needn’t take on product-liability and asbestos claims from before the transaction is completed.

Liability Costs

GM estimated the cost of future product liability claims at $921 million and asbestos-related tort claims at $648 million as of the end of 2008, according to a regulatory filing.

Barry Bressler, a lawyer representing more than 300 tort claimants with what he estimated as $1.25 billion in claims against GM, said Gerber’s ruling “was not unexpected.” He declined to say whether he would appeal.

Bressler, who also represented tort claimants in the Chrysler case, has asked the U.S. Supreme Court to review the liability issues. The court, which declined to halt the Chrysler sale, hasn’t decided whether to hear that petition.

Jakubowski said it was possible the Supreme Court might consolidate his appeal with Bressler’s and decide both simultaneously.

It may be difficult to get the Supreme Court to take up the Chrysler petition now after the sale has closed, because it could be considered moot, Lubben said.

Bankruptcy Sales

The issue needs to be addressed because so many companies are selling their assets through quick “363 sales” in bankruptcy, cutting off existing liability, Jakubowski said. He argued along with Richman at a three-day hearing before Gerber that GM should file a traditional Chapter 11 reorganization plan and seek creditors’ votes, a process that might take months.

GM and the Treasury argued the company wouldn’t survive a traditional Chapter 11 case. The government said before the ruling that it would pull its $33 billion in financing if Gerber didn’t approve the sale by July 10.

Gerber agreed in his ruling.

“As nobody can seriously dispute, the only alternative to an immediate sale is liquidation -- a disastrous result for GM’s creditors, its employees, the suppliers who depend on GM for their own existence, and the communities in which GM operates,” Gerber said in an 87-page opinion.

Should the sale close in its current form, the U.S. government would get 60 percent of the new GM for making $50 billion in bailout loans, a United Auto Worker retiree trust would get a 17.5 percent stake, and two Canadian government entities would get an 11.7 percent equity share for their loans.

Old GM’s Equity

Old GM would get 10 percent of the equity, plus warrants, to distribute to bondholders and unsecured creditors.

“This was a bailout of the UAW, not of GM,” said Peter Kaufman, president of the Gordian Group LLC and an adviser to the Family and Dissident Bondholders. “It’s a tragedy. Twenty- seven billion dollars of bonds, many if not the majority of which are owned by mom and pop, have been essentially wiped out.”

The estimated recovery on unsecured claims range from 10 cents to 20 cents on the dollar, Bressler said. His “economically fragile class” of clients may have to wait years for that recovery and would be under pressure to liquidate any stock and warrants they receive to cover medical bills, he said.

The case is In re General Motors Corp., 09-50026, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Christopher Scinta in New York at csinta@bloomberg.net.

By Scott Lanman and Steve Matthews

July 7 (Bloomberg) -- Goldman Sachs Group Inc. says when it comes to inflation, the Federal Reserve can relax. That kind of talk makes Morgan Stanley nervous.

Joachim Fels, co-chief global economist at Morgan Stanley, sees a risk that the Fed will keep the easiest credit since the Great Depression for too long. Ed McKelvey, U.S. economist at Goldman in New York, says those concerns are overblown, and that officials have time to deploy as many as 10 options for ending their $1.1 trillion aid to the banking system and economy without letting consumer prices climb.

The debate underscores a widening division among economists over whether the central bank will hold onto the gains it’s achieved in fighting inflation over the past three decades. Record liquidity injections and a projected federal budget deficit of $1.85 trillion threaten to undermine that legacy.

“The greater risk is they keep accommodation too long rather than tighten too quickly,” Fels, who’s based in London, said in an interview. “The price they would then pay is higher inflation for keeping the economy afloat.”

A measure of inflation expectations watched by Fed officials rose “closer to the 2 percent level” in recent months after being “very negative late last year,” St. Louis Fed President James Bullard said in a June 30 presentation in Philadelphia. He also said investors “are not expecting a lot of inflation over the next five years.”

The Fed’s preferred price gauge, which excludes food and energy prices, rose 1.8 percent in May from a year earlier. Fed officials expect inflation in a range of 1.7 percent to 2.0 percent over the longer term, according to minutes of April’s Federal Open Market Committee meeting.

Meltzer’s View

“I agree with Morgan Stanley that the markets are too sanguine about inflation,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.”

Goldman Sachs says the risk is in the other direction, that the Fed may have a tougher time easing credit further should the economy deteriorate. Jan Hatzius, the company’s chief U.S. economist in New York, said in a July 1 research note that it’s “very unlikely” the Fed will “lose control” of inflation and that the Fed should err on the “accommodative side” of monetary policy.

‘Screw-Up’ Scenario

“The market seems to have a bias in its thinking that somehow the Fed is going to totally screw up,” resulting in inflation, McKelvey, who used to work at the Fed, said in an interview. He cited conversations with clients and what he’s read in the press, as well as the rise in Treasury yields and trader expectations of Fed interest-rate increases in recent weeks.

McKelvey, who wrote a June 30 note outlining the Fed’s options, cautioned there’s no guarantee the Fed will get it right, and “political constraints” might prevent the central bank from using its tools.

The Fed lowered its main interest rate almost to zero in December, switching to asset purchases and credit programs as the main policy levers. Chairman Ben S. Bernanke is leading plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt by year-end, along with $300 billion of long-term Treasuries by September.

Bernanke’s Options

Bernanke has three sets of tools, about 10 options total, for unwinding credit, McKelvey said. They include the reduction or end of non-emergency and emergency lending programs; selling or ceasing purchases of securities; and reducing bank reserves using tools such as the issuance of Fed debt.

“This one’s easy: Morgan Stanley is wrong and Goldman is right,” said Mark Gertler, a New York University economist and research co-author with Bernanke. “The Fed will be able to contain inflation pressures through a combination of raising interest rates and unwinding its balance sheets.”

The expansion of the Bank of Japan’s balance sheet also had no effect on inflation in that country, Gertler said.

The Fed took a first step last month toward ending its efforts to revive credit, deciding to let one emergency lending program expire and trim two others. Bullard said last week that policy makers need to craft a broader plan for unwinding the asset purchases to reduce inflation risks and bolster confidence in an economic recovery.

“The Fed needs to reduce some of the uncertainty in markets about how the exit strategy looks,” said Fels. “They can’t tell us when, but there needs to be more transparency on the how.”

Interest on Deposits

Some top Fed officials have said they plan to rely on raising the rate paid on banks’ deposits with the Fed as a major component of the central bank’s strategy to tighten credit.

Bernanke has a chance to give a more detailed outline of the Fed’s exit strategy on July 21, when he delivers the Fed’s semiannual monetary policy report to Congress and testifies before the House Financial Services Committee.

The Fed has increased total assets on its balance sheet by $1.1 trillion in the past year to $2.01 trillion as of July 1 to unfreeze credit markets and support banks’ demand for cash. Short-term lending to commercial banks and bond dealers has declined in recent weeks, owing in part to falling costs for private borrowing.

Yellen Warning

Goldman’s views may be shared by some Fed officials. San Francisco Fed President Janet Yellen said in a June 30 speech to the Commonwealth Club of California that the “predominant risk” is that inflation will “be too low, not too high, over the next several years.”

Inflation excluding food and energy may fall to about 1 percent over the next year and remain below 2 percent, with an unlikely possibility of turning into deflation if the economy fails to recover soon, Yellen said.

Another Fed district bank president, Charles Evans of Chicago, told reporters in London on July 1 that he also sees inflation falling “a bit from where we are now.”

“I don’t worry about the technical ability of the Fed to do it,” Martin Feldstein, a professor of economics at Harvard University, said in a Bloomberg Radio interview July 1. “What worries me is the political hurdle that they would be facing.” Congress won’t “easily” digest the Fed’s desire to limit lending and restrict inflation, Feldstein said.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.