0001 1 BEFORE THE UNITED STATES 2 FEDERAL ENERGY REGULATORY COMMISSION 3 4 - - - - - - - - - - - - - - - - - -x 5 In the Matter of: : IN-10-05-000 6 PJM UP-TO-CONGESTION TRANSACTIONS. : 7 - - - - - - - - - - - - - - - - - -x 8 9 10 REDACTED REDACTED 13 14 15 16 Washington, D.C. 17 Monday, May 14, 2012 18 19 20 21 22 REPORTED BY: 23 SARA A. WICK, RPR, CRR 24 25 0002 1 Confidential deposition of RICHARD G. WALLACE, called 2 for examination pursuant to agreement of counsel, on 3 Monday, May 14, 2012, in Washington, D.C., at the Federal 4 Energy Regulatory Commission, 888 First Street Northeast, 5 Hearing Room 2, at 10:12 a.m., before SARA A. WICK, RPR, 6 CRR, and a Notary Public within and for the District of 7 Columbia, when were present on behalf of the respective 8 parties: 9 10 STEVEN TABACKMAN, ESQ. 11 JAMES OWENS, ESQ. 12 Federal Energy Regulatory Commission 13 Office of Enforcement 14 888 First Street Northeast 15 Washington, D.C. 20426 16 steven.tabackman@ferc.gov 17 On behalf of the FERC 18 19 -- continued -- 20 21 22 23 24 25 0003 1 APPEARANCES (continued): 2 3 WILLIAM M. MC SWAIN, ESQ. 4 Drinker Biddle & Reath LLP 5 One Logan Square 6 Suite 2000 7 Philadelphia, Pennsylvania 19103 8 william.mcswain@dbr.com 9 On behalf of Powhatan Energy Fund and 10 the Witness 11 12 Also Present: Cathleen Colbert, Brett Rudder 13 14 15 16 17 18 19 20 21 22 23 24 25 0004 1 P R O C E E D I N G S 2 Whereupon, 3 RICHARD G. WALLACE 4 was called as a witness and, having first been duly sworn, 5 was examined and testified as follows: 6 EXAMINATION 7 BY MR. TABACKMAN: 8 Q We are on the record. Sir, would you, please, 9 state your full name for the record. 10 A Richard Greene Wallace. 11 Q And where are you employed, Mr. Wallace? 12 A I'm employed at the law firm of Foley & Lardner 13 LLP. 14 Q Let me do some introductions here formally for 15 the record. My name is Steven Tabackman. I am a member of 16 the FERC Staff that is investigating this matter, and this 17 is an investigation into the up-to-congestion trading in 18 the PJM market. It is a formal investigation. It is a 19 nonpublic investigation, Docket Number IN-10-5-000. 20 Do you understand that? 21 A Yes, I do. 22 Q To my right is James Owens. He is also a staff 23 member of the Commission, the Division of Investigations in 24 the Office of Enforcement. And sitting over there are two 25 folks from the newly formed Division of Analytics and 0005 1 Surveillance, used to be known as Energy Market Oversight. 2 The young lady is Cathleen Colbert. The young man is Brett 3 Rudder. And I don't mean to be disparaging. It's just 4 that everybody is younger than I am these days. And they 5 are also working on this matter. 6 I will be asking most of the questions. 7 Mr. Owens may have some questions for you, as well as 8 Mr. Rudder or Ms. Colbert. We will try not to do this in a 9 way that it feels like you're getting ganged up on, but I 10 suspect you're able to handle all of that. 11 You are an attorney; is that correct? 12 A Yes, I am. 13 Q And do you have counsel here today? 14 A Yes, I do. 15 Q Who is that? 16 A Mr. William McSwain. 17 MR. MC SWAIN: If I may introduce myself. Bill 18 McSwain from Drinker Biddle, on behalf of the Powhatan 19 Energy Fund. 20 BY MR. TABACKMAN: 21 Q You have participated in a number of depositions 22 in your life, I am sure? 23 A Yes. 24 Q You understand that the lady over here is a 25 court reporter, and she is taking down everything that you 0006 1 say? 2 A Correct. 3 Q You understand that you are under oath? 4 A Yes. 5 Q And sworn to tell the truth? You understand 6 that a knowingly false statement under oath can be 7 prosecuted as perjury or a false statement, in this 8 particular investigation in particular because this is a 9 formal investigation and Mr. Owens and I are designated as 10 officers of the Commission? 11 Do you understand that? 12 A Yes, I do. 13 Q Are you under any medication or is there any 14 disability that you're under that would keep you from being 15 able to understand questions and to answer them truthfully 16 to best of your ability? 17 A No, sir. 18 Q Mr. Owens reminds me, I should remind you that 19 you also have a Fifth Amendment privilege not to answer any 20 questions that would tend to incriminate you. However, if 21 you were to take the Fifth Amendment, and because you're 22 simply a witness here and not a participant in any of these 23 underlying transactions, this is all sort of beside the 24 point, but you understand that inferences could be drawn if 25 you were to make such an assertion. 0007 1 Do you understand that? 2 A I understand. 3 Q If you need a break at any time, please let me 4 know, and we will do that. If there's a question that's 5 pending, we will wait until after we get the answer, but 6 other than that, just let me know. You need to answer yes 7 or no. 8 A Okay. 9 Q Also, you understand that we're going to both 10 try to do our best not to talk over each other. If you 11 wait until I finish asking the questions -- and sometimes I 12 pause and that's a problem, but I will do my best to signal 13 clearly when the question is over. And I will try not to 14 talk over you when you're giving an answer. 15 Is that fair? 16 A I will try not to talk over you, too. 17 Q Thank you. You submitted an affidavit in this 18 matter on behalf of Powhatan Energy Fund, LLC; is that 19 correct? 20 A Yes, sir. 21 MR. TABACKMAN: If we could have this marked as 22 Exhibit 1, please. 23 (Exhibit Wallace 1 identified.) 24 BY MR. TABACKMAN: 25 Q Take a look at what's been handed to you as 0008 1 Exhibit 1, and tell me if that is the affidavit that you 2 submitted, the entirety of it, on behalf of Powhatan Energy 3 Fund, LLC? 4 A Yes. 5 Q How did you come to be involved in this matter, 6 Mr. Wallace? I don't want you to disclose any 7 communications that would disclose any kind of privilege 8 that you and Mr. McSwain have about any confidential 9 communication, but your understanding of how it is that you 10 came to give this affidavit. 11 A A few weeks before the affidavit was signed, 12 Mr. McSwain called me and explained to me the broad 13 strokes, the nature of the investigation, and the use of 14 Rule 10b and Section 10(b) -- Rule 10b-5 and Section 10(b) 15 of the securities laws in the Federal Energy regulation 16 laws and was interested in knowing if I would be interested 17 in serving as an expert witness on the questions of wash 18 sales, manipulations in securities markets and how that 19 might shed light on trading in the energy markets. 20 Q And I should say, I am not going to ask you to 21 look at documents and explain in detail or challenge your 22 opinions in any way here today. I don't know if 23 Mr. McSwain has told you this, but this is simply an effort 24 to ascertain what it is that you relied on in preparing 25 your affidavits. So we won't get to the kinds of questions 0009 1 one might typically have with an expert, like would this 2 change your opinion if you saw this. I want to try to 3 understand what it is that's written here and what you did 4 so you could get to the point that you could write this 5 affidavit. 6 MR. MC SWAIN: If I could interrupt and note for 7 the record, that is my understanding of the purpose of this 8 deposition from conversations with Mr. Tabackman in the 9 past, that the deposition is try to understand better the 10 factual bases and what materials, for example, Mr. Wallace 11 looked at in coming up with his opinion, but is not a 12 typical expert deposition in the sense that we're not going 13 to get into substantive questions and answers about the 14 analysis itself. 15 MR. TABACKMAN: That's correct. If there's a 16 couple of sentences that I may not understand what they 17 mean, I may ask him to explain what they mean. Beyond 18 that, we won't get into any matters of Mr. Wallace's 19 analysis versus any analysis that we may have. 20 BY MR. TABACKMAN: 21 Q The affidavit -- after you received or were 22 contacted, rather, by Mr. McSwain, what happened next in 23 terms of your preparation? 24 A Mr. McSwain provided me with information so I 25 could make sure there were no conflicts of interest and 0010 1 such. We entered into discussions about what my role might 2 be, what areas of expertise. He asked me background 3 questions about what I had done and my involvement in the 4 securities industry and regulation in the securities 5 industry. He then provided me with some materials that 6 pertained to this. The ones that come to mind are the 7 submissions that the law firm of Skadden, Arps had made for 8 Dr. Chen. We had some phone calls discussing the nature of 9 the case. There was a meeting held at the offices of 10 Skadden, Arps in September where I met with Dr. Chen. 11 Q September of 2011? 12 A Yes. And then there was a -- in connection with 13 that, I also talked with Mr. Kevin Gates before that 14 meeting. And then in October, I think it was the 14th of 15 October, I met in Philadelphia with Mr. Gates, and counsel 16 was present at that meeting, too. Then there were various 17 phone calls and other materials provided to me throughout 18 the course of preparing the affidavit. 19 Q Taking a look at paragraph 2 of Exhibit 1, is it 20 fair to characterize that as a summary of some of the 21 things that you looked at? 22 A Yes. 23 Q Okay. I just want to go through them. It 24 says "I have familiarized myself with the details of this 25 investigation through conversations with Dr. Chen and Kevin 0011 1 Gates." Again, you referenced a meeting that occurred at 2 Skadden, Arps in September of 2011? 3 A Correct. 4 Q Who was there at that meeting? 5 A Mr. McSwain, Dr. Chen, attorneys at Skadden, 6 Arps whose names escape me right at the moment. 7 Q Does the name John Estes ring a bell? 8 A That could very well be the person. 9 Q Okay. 10 A Richard Tabor was on the phone, but not present. 11 An associate of mine in the Chicago office of Foley & 12 Lardner, Miriam Ahmed, was on the phone for the first hour 13 or so of the meeting. There were other attorneys. 14 MR. MC SWAIN: Other attorneys from White & 15 Case, right. And I don't mean to be testifying here, but 16 did you mention Mr. Gates himself? 17 THE WITNESS: Mr. Gates. 18 BY MR. TABACKMAN: 19 Q Kevin Gates? 20 A Yes. 21 Q But not Richard Gates? 22 A No. 23 Q And again, the purpose of that meeting was what? 24 A For Dr. Chen to sort of explain how the trading 25 worked, provide some background, information about trading 0012 1 in general. 2 Q Did you take notes of what he was saying? 3 A I did. 4 Q And did you keep those notes? 5 A Yes, I did. 6 Q We may be seeking those notes from you. Do you 7 know if Ms. Ahmed took notes? 8 A I assume she did. She has since left our firm. 9 The reason she was only on the call for an hour was 10 Dr. Chen's accent was -- is pretty strong, and he was at 11 times, you know, drawing on an easel, and over the phone, 12 it was sort of incomprehensible. 13 Q Okay. I understand. So Dr. Chen explained his 14 trading. Did you ask him questions? 15 A I believe I asked him a few questions. 16 Q And was that in connection with understanding 17 the trading better? 18 A Yes. 19 Q Did Kevin Gates provide any information that you 20 relied on in the course of that meeting? 21 A I don't remember Mr. Gates saying anything 22 during that meeting other than, you know, hello or 23 whatever. Now, we did talk before that meeting on that 24 same day. 25 Q You and Mr. Gates did? 0013 1 A Yes. 2 Q In the presence of counsel? 3 A Yes. 4 Q And what did you and Mr. Gates talk about? 5 A He described his relationship with Dr. Chen and 6 how the relationship had progressed over time. 7 Q Again, going to your preparation and back to 8 Dr. Chen, you said he drew some things on the board. Do 9 you recall what that was? 10 A They were attempts to illustrate how the 11 up-to-congestion trading worked. He would sort of draw a 12 node inside the PJM and another node outside the PJM and 13 sort of say here's a transaction this way and another 14 transaction. I believe he wrote some formulas out so that 15 you could sort of, you know, say you've got this on this 16 side of the equation and something else on the other side 17 of the equation and they cancel out and here's what you're 18 left with, those kinds of things. 19 Q I think I have a sense of what he might have 20 drawn for you, but talking about how PJM arrived at price 21 spreads between two nodes -- 22 A Right. 23 Q -- and the formulas that they applied? Does 24 that ring a bell? 25 A Correct. 0014 1 Q And he would have source minus sink on one side, 2 settling one side of a transaction and sink minus source on 3 the other? Is that a part of what he explained to you? 4 A That seems to be a fair characterization. 5 Q And did he characterize his purpose when he was 6 doing these kinds of trades where that involved these two 7 different transactions and this formula that you're talking 8 about? Let me see if I can clarify. 9 A I'm just trying to say, he was describing, I 10 think, the motivation for doing it and sort of some of the 11 risks and some of the rewards involved in the transactions. 12 Q In the course of that, did you ask him whether 13 or not if both sides of the transactions cleared in these 14 two nodes whether he would be able to make any money off of 15 the spreads? 16 A I don't believe I asked him that question. 17 Q Did he address that question, as you recall? 18 MR. MC SWAIN: If I could just clarify, you're 19 talking about two nodes. Are we talking about nodes 20 theoretical or some specific nodes? 21 MR. TABACKMAN: I'm trying to understand what 22 Dr. Chen was explaining to him. Mr. Wallace mentioned 23 there was something about nodes inside PJM and outside PJM. 24 THE WITNESS: And I believe that Dr. Chen was 25 talking about actual nodes that were involved, but I think 0015 1 the pricing that he discussed was also hypothetical, if the 2 price was X and the price in the other direction was Y, 3 here's what the result would be. 4 BY MR. TABACKMAN: 5 Q And did you address the question hypothetically 6 in this with Dr. Chen if the price was X and Y in one 7 direction, under these formulas that he was explaining, did 8 you have any understanding as to how he would profit from 9 these transactions? 10 A Yes. 11 Q What was your understanding? 12 A If the transactions in both directions cleared, 13 I believe is the correct terminology, then there would be 14 the -- the financial underlying conversations would net 15 out, to a large extent. There would be certain costs that 16 would remain, and then there would be a transmission loss 17 credit that might be advantageous, but he was unsure at 18 many times what that transmission loss credit would be. 19 Q Did you -- did Dr. Chen address, again in terms 20 of your understanding these transactions to prepare them, 21 whether he had anything that he may have done to determine 22 what -- try to determine in advance what transactions -- 23 transmission loss credits there might be on these 24 hypothetical transactions? In other words, how he went 25 about doing his job of doing trading? 0016 1 A I believe Dr. Chen said that at a certain point 2 he had acquired more information about the transmission 3 loss credits and had, to choose my words carefully, an 4 improved understanding of what they might be. But when he 5 first received the transmission loss credit, he did not 6 know how they were calculated, and that for some period of 7 time after that, it was a very obscure or dark process. 8 There wasn't a lot of transparency. I think at a certain 9 point, he had a certain degree of confidence about what the 10 range of loss credits would be. But I don't think he ever 11 had a clear understanding on a certain day how much of a 12 transmission loss credit he would earn. 13 Q If I can make sure I understand your answer, he 14 would -- I take it, then, that you understood him to say 15 that he had studied these and tried to at some point reach 16 an understanding of -- or at least a better understanding, 17 to use your word, an improved understanding of how PJM 18 would give these transmission loss credits; is that fair to 19 say? 20 A Right. And I believe that that process occurred 21 sort of later in the trading. It was not near the end when 22 he became a little better able to estimate the transmission 23 loss credits. 24 Q When you say "near the end," what is your 25 understanding of the length of period of time -- the length 0017 1 of time that Dr. Chen was addressing when he was describing 2 these trades? 3 A I believe they stopped in the summer of 2010. 4 Q And do you recall -- and when he was addressing 5 these, what was the beginning point, if you recall? 6 A I'd have to say I don't recall what the 7 beginning point of his understanding of the transmission 8 loss credits. 9 Q Relative to -- you said that he began to 10 understand toward the end of the trading. Relative 11 towards -- and you are correct that the trading ended in 12 August of 2010. Relative to that period of time, did you 13 get a sense of when Dr. Chen finally arrived at this 14 improved understanding? 15 A I couldn't be more specific than to say it was 16 near the end, springtime or something like that. 17 Q Springtime of 2010? 18 A That's my best recollection. 19 Q Had you ever been involved in a matter that 20 involved energy trading prior to getting involved in this 21 matter? 22 A No, sir. 23 Q I take it, then, the discussion of how energy 24 trading or electricity trading, in particular, in these 25 marketplaces was something that you had to get educated 0018 1 about; is that correct? 2 A Absolutely. 3 Q Did you come to understand that there would -- 4 did Dr. Chen explain -- or in your readings the notion of 5 clearing prices and bids? 6 A Yes. 7 Q What do you recall Dr. Chen telling you about 8 that or your understanding about that? 9 A I recall Dr. Chen explaining that if the up-to 10 congestion exceeded a certain level, which I believe was 11 $50, that the transaction would not clear and that if you 12 had two transactions that were basically going in opposite 13 directions, if one didn't clear, the other one would have 14 to clear. 15 Q I take it he explained why that was? 16 A It was sort of a mathematically formula. 17 Q Okay. And did he talk about how he arrived at 18 what he might bid on any of these hypothetical 19 transactions, the process that he went through? 20 A He described putting different up-to congestion 21 limits on different trades, but I do not believe -- or I 22 don't recall whether he described how he arrived at 23 sometimes he would put them $1 figure and sometimes he 24 would put a lower dollar figure. I don't recall. 25 Q Did he describe whether or not, in arriving at 0019 1 his dollar figures, he was trying to have his legs clear or 2 not trying to have his legs clear? 3 A I believe he said that he did not intend for 4 each leg to clear in every case, but my recollection here 5 is I know people said that at different times. I can't say 6 with 100 percent certain that that's something that 7 Dr. Chen said at that meeting or that that's something I 8 had heard earlier. There was certainly a discussion of 9 some trades not being priced at the maximum congestion 10 limit, some being priced at a lower level, and then those 11 discussions, I remember hearing before the meeting with 12 Dr. Chen, after the meeting with Dr. Chen, I believe during 13 the meeting with Dr. Chen, but I can't be 100 percent 14 certain on that. 15 Q And with whom did you have discussions about 16 this clearing before the meeting with Dr. Chen? 17 A With counsel, with Mr. Kevin Gates, and I 18 remember reading it in the submissions that Skadden, Arps 19 had made. 20 Q Subsequent to the meeting -- and I think we're 21 talking about the meeting that was in September, is that 22 correct, 2011? 23 A Yes. 24 Q Subsequent to that meeting, did you talk with 25 Dr. Chen again? 0020 1 A No. 2 Q Did you speak with Kevin Gates again? 3 A I did speak with Mr. Gates again. 4 Q That was in October of 2011? 5 A Correct, in Philadelphia. 6 Q And what was the purpose of that meeting? 7 A I happened to be in Philadelphia on other 8 business and arranged to meet with counsel and Mr. Gates to 9 go over a few parts of the affidavit that had come up 10 recently. 11 Q Did you share drafts, one or more drafts of your 12 affidavit with counsel for Mr. Gates prior to your arriving 13 at the final? 14 A Yes. 15 Q And did -- as a result of their review, did you 16 change anything in your affidavit? 17 A Yes. 18 Q Can you -- if you would look through it and tell 19 me which areas at least were changed as a result of that, 20 those conversations? 21 A I can't recall any specific changes. There were 22 word changes. There were order changes. There were typos. 23 MR. MC SWAIN: Not very many of those. 24 THE WITNESS: Changes throughout the document. 25 I don't believe there were any significant substantive 0021 1 changes. The basic points that I was making stayed the 2 same, as I recall. 3 MR. MC SWAIN: I think we're getting a little 4 close to where we shouldn't go. 5 MR. TABACKMAN: Right. I'm not going to go any 6 further than that. I'm trying to understand, again, the 7 genesis of the document. 8 BY MR. TABACKMAN: 9 Q After that meeting in Philadelphia in October, 10 did you have any further telephone conversations with 11 either Mr. Gates or Dr. Chen or anyone else from Powhatan 12 other than counsel? 13 A I don't believe so. 14 Q Going back to paragraph 2, you read -- it says 15 here that you reviewed various materials, including the 16 deposition transcripts and related exhibits of Kevin 17 Gates's depositions dated September 23, 2010, September 7, 18 2011. Did you read those before or after the meeting in 19 September 2011 with Skadden, Arps? 20 A I'm pretty sure I read them before. 21 Q And did you discuss the testimony of Mr. Gates 22 with him? 23 A No. 24 Q And you had a set of exhibits that were used in 25 connection with the deposition? 0022 1 A They were not the actual exhibits, marked as 2 exhibits, but I think they re-created the same e-mails that 3 Staff had discussed with the witness. 4 Q And did you discuss those e-mails with 5 Mr. Gates? 6 A No. We didn't say here's an e-mail, or I didn't 7 ask him about e-mails, but subjects in the e-mails and in 8 the testimony may have been discussed with Mr. Gates and I, 9 but we weren't saying you said this in your testimony or 10 this was in the exhibit. We were talking generally about 11 trading. 12 MR. TABACKMAN: Again, just to make sure I know 13 what you may or may not have spoken to him about, can I 14 have this document marked as Exhibit 2. 15 (Exhibit Wallace 2 identified.) 16 BY MR. TABACKMAN: 17 Q I've given a copy to counsel. Take a look at 18 that, please, and let me know -- the only question I have 19 is do you recall if this is one of the e-mails that you saw 20 and/or spoke with Mr. Gates about? 21 A I know for a fact we did not discuss this e-mail 22 as such. There was no reference to particular e-mails. We 23 may have discussed the subjects in here, but sort of 24 reading the e-mail, I don't recall even discussing this 25 back and forth or anything like that. 0023 1 Q Okay. Let me just, so that the record is clear, 2 identify the document that we are referring to. Exhibit 2 3 is Bates numbered POW and the last digits are 11676, and 4 it's a -- purports to be an e-mail from Alan Chen to Kevin 5 Gates of Friday, March 5, 2010. I take it, again, without 6 getting into the details of the e-mail, the subject matter 7 generally, TLCs are referenced in here and the trading. 8 You did discuss that with Mr. Gates? 9 A I see here there's a discussion of the 10 shoulders. I remember that subject being discussed by 11 Dr. Chen. 12 Q They're talking about the TLC advantage. It 13 says here in the middle of the paragraph "TLC advantage 14 tends to shrink a lot during shoulder months." 15 A Correct. 16 Q That rings a bell with you? 17 A Yes. 18 Q Do you recall Dr. Chen giving you any further 19 explanation of what a shoulder month was? 20 A Something having to do with the beginning and 21 end of the summer, something like that. Energy use is not 22 quite as high as during the peak summer months. 23 Q Did you understand that was a time, therefore, 24 when TLCs, these transmission loss credits, might be 25 reduced? 0024 1 A Yes. 2 Q Another subject that's in here, again without 3 referencing the specific numbers, did you discuss in the 4 course of your preparation the subject of money being lost 5 on the trade itself but making a profit on the TLCs in any 6 given month? 7 MR. MC SWAIN: I would object to that 8 characterization of "the trade itself." 9 BY MR. TABACKMAN: 10 Q It's a distinction that is in the documents that 11 went back and forth between Dr. Chen and Powhatan. But in 12 any event, the spread, the price spread and making money on 13 that versus making money as a result of the transmission 14 loss credits. 15 A And the question is, did I remember Dr. Chen 16 talking about that? 17 Q Yes. 18 A Yes, I believe he did discuss that. 19 Q Did you talk about that also with Kevin Gates? 20 A Yes. 21 MR. TABACKMAN: I'm going to have this next 22 document marked as Exhibit 3. 23 (Exhibit Wallace 3 identified.) 24 BY MR. TABACKMAN: 25 Q Again, I'm giving one to counsel. Just to 0025 1 identify it for the record, Exhibit 3 is a three-page 2 document bearing Bates numbers POW 11501 through 11503; is 3 that correct? 4 A Yes. 5 Q And it appears to be an e-mail chain or thread 6 back and forth between Kevin Gates and Alan Chen, is that 7 an accurate description, on or about April 7th of 2010? 8 A Correct. 9 Q Again, let me read to you the beginning here on 10 the second page. It says -- on Wednesday, April 7th, Alan 11 Chen wrote "Attached please find the March 2010 statement 12 for HEEPF." 13 Do you know what that refers to? 14 A It's a fund. I don't -- 15 Q One of the funds? 16 A Yes. 17 Q "HEEPF's total monthly PnL is $93,485.93 ( = 18 -$84,792.16 + $178.278.09)." In the next 19 paragraph, "Attached please also find the March 2010 20 statement for HUNT2." 21 Do you know what that refers to, "HUNT2"? 22 A That's another fund. 23 Q Do you know who owned HUNT2? 24 A No, I don't. 25 Q "HUNT2's total monthly PnL is $372,267.68 ( = 0026 1 -$340,923.69 + $713,191.37)." 2 Did I read that correctly? 3 A It appears to be, yes. 4 Q And moving to the first page, 11501, the second 5 e-mail down -- well, strike that, the third one down, the 6 one that begins on Wednesday, April 27th, at 11:43, Alan 7 Chen wrote "Hi Kevin, Some of the TLC trades I put in lost 8 money and they are also shown in PnL so overall I would say 9 half and half." 10 And that was in response to -- I should read 11 this other one also. Kevin Gates had written before 12 that "You made a little bit more money than you originally 13 thought. That's nice. 14 "But, I thought you were expecting about half of 15 the money to come from P&L, and half from TLC? Obviously, 16 it would have been a very bad month if not for the TLC. 17 Why was this surprising, and do you have any new thoughts 18 re: the TLC trade?" 19 Did I read that correctly? 20 A Yes. 21 Q And then Dr. Chen responded on April 7th "Kevin, 22 Some of the TLC trades I put in lost money and they are 23 also shown in PnL so overall I would say half and half." 24 Did I read that correctly? 25 A Yes, you did. 0027 1 Q Kevin Gates responded to Dr. Chen "Alan, I'm 2 confused. We made $713,321.73 in TLC, but lost $340,923.69 3 otherwise. Maybe, we can talk today after the markets 4 close about this? Let me know your availability." 5 Did I read that correctly? 6 A Yes, you did. 7 Q And finally, Dr. Chen responds to Kevin Gates, 8 again on April 7th, "Hi Kevin, what I'm saying is that if I 9 didn't have those extra trades in just for TLC, I'd have 10 made some money. For every single TLC trade, we would lose 11 money on PnL and make money on TLC so it is just shifted. 12 If you want to talk, please let me know. I'll be available 13 this afternoon." 14 Did I read that correctly? 15 A Yes. 16 Q Again, does that topic of losing money and how 17 money was made and lost on these trades something that you 18 discussed with Dr. Chen and Mr. Gates as a part of your 19 preparation for doing your affidavit? 20 A Yes, without discussing these dollar figures or 21 this e-mail in particular. 22 Q Were you familiar with equities cases that were 23 like that in your experience at FINRA and the Securities 24 and Exchange Commission? 25 A Like that? 0028 1 Q In the sense that there would be a loss on a 2 trade versus then having -- for example, how there was lost 3 money on the P&L but made $713,000 in TLC, that kind of a 4 transaction, were you familiar with those in the equities 5 markets? 6 A Well, in my affidavit, I talk about trading 7 where one of the key components is rebates, trade or tape 8 rebates, liquidity rebates, other kinds of rebates that go 9 into the market participant's overall decision on whether 10 or not to trade. 11 Q In preparing your affidavit, is that something 12 that you had recalled seeing cases like that, or did 13 someone bring those to your attention? 14 A No, I'm familiar with those cases. 15 Q And was that from your period at the Commission 16 or FINRA or both? 17 A My time at FINRA. 18 MR. TABACKMAN: If I could have this marked as 19 Exhibit 4. 20 (Exhibit Wallace 4 identified.) 21 BY MR. TABACKMAN: 22 Q I'm providing a copy to counsel. Take a look at 23 this, and let me know when you're finished looking it over. 24 A Okay. 25 Q Again, Exhibit 4 is a two-page document, though 0029 1 the second page simply has confidentiality notices and 2 addresses. They bear POW 11709 and 11710 as the Bates 3 numbers, and again, it's another e-mail thread between Alan 4 Chen and Kevin Gates, March 5, 2010. 5 Have I accurately described the document? 6 A Yes. 7 Q The top e-mail is from Alan Chen to Kevin Gates 8 on March 5th, and I'm going to read it into the record, it 9 says "Hi Kevin, Before and in January 2010, I didn't 10 specifically target for TLC. Starting in February 2010, I 11 kicked up a notch targeting for TLC. In March 2010, I 12 added some more. Without TLC, I would not touch some of 13 the trades and/or would not put in large volumes for some 14 of the trades. But with TLC as is, they are suddenly 15 becoming risk-free (almost to the point) trades. I'll take 16 down a little bit starting tomorrow knowing that we are 17 leaving a lot of money on the table." 18 Did I read that correctly? 19 A Yes, you did. 20 Q Do you recall whether you saw this e-mail in the 21 course of preparing for your affidavit? 22 A I don't recall it specifically, but if it was in 23 the package of materials that counsel provided me as 24 exhibits to the deposition, then I did review them. 25 Q Do you recall talking about this topic of 0030 1 specifically targeting for TLC and the words I just read? 2 A We did not discuss this e-mail with Mr. Gates or 3 Dr. Chen. We did talk about increasing trading in the 4 up-to congestion markets and the greater transparency 5 Dr. Chen had as to how TLC might -- "calculate" is probably 6 too precise a word, but what they might end up being for 7 any day as that spring of 2010 progressed. 8 Q Okay. Do you recall the words "targeting for 9 TLC" in your efforts to understand these transactions 10 better? 11 A No, not in any discussion that I had with 12 Dr. Chen or Mr. Gates. 13 MR. TABACKMAN: If I could have this marked as 14 Exhibit 5, please. 15 (Exhibit Wallace 5 identified.) 16 MR. TABACKMAN: I'm giving a copy to counsel. 17 MR. MC SWAIN: I don't have any objection, by 18 the way, if you just want to ask direct questions about an 19 e-mail so you don't have to read them every time, unless 20 you just feel a need to do that. 21 MR. TABACKMAN: No, I don't. 22 THE WITNESS: Okay. 23 BY MR. TABACKMAN: 24 Q Exhibit 5 bears Bates numbers POW 4485 and 4486. 25 It's again an e-mail thread. Do you recall discussing with 0031 1 Alan Chen at any time -- again, there's a reference in the 2 top e-mail about moving the market. It's an e-mail from 3 Chao Chen. Do you know if he's related to Alan Chen? Does 4 that name ring a bell to you, Chao Chen? 5 A It does not. 6 Q This is from Chao Chen to Kevin Gates, dated 7 July 12th, and there's a discussion of moving the market, 8 which references other e-mails that Alan Chen had sent to 9 both Chao Chen and Kevin Gates. 10 Do you recall that subject coming up, the 11 subject of whether or not any of the trades that Dr. Chen 12 was making were moving the market? 13 A No. 14 Q I believe the second e-mail down is from Kevin 15 Gates -- no, it's from Alan Chen to Kevin Gates. The 16 bottom one on that page is from Kevin Gates to Alan Chen. 17 One of the things Kevin Gates was asking about the basis 18 for a loss that had been suffered in the trades that are 19 described on the second page of the e-mail thread. 20 Do you recall -- and Kevin Gates asks, if I can 21 characterize it, was the problem here that -- "To clarify, 22 this loss wasn't the result of your not getting both legs 23 of the trade on, right?" 24 And Alan responds "That's correct," and he 25 explains the factors that did lead to the loss on that 0032 1 date. 2 Again, you said you did recall having a 3 discussion about legs not clearing? 4 A Yes. 5 Q Do you recall discussing other basis for losses 6 that -- or come to understand the trades, as they sometimes 7 had -- strike that. 8 Did you discuss with Dr. Chen, in terms of your 9 understanding of the transactions, the risks that were 10 involved in these trades? 11 A Yes. 12 Q And what did Dr. Chen tell you about the risks 13 that were involved in the trades? 14 A The main risk we talked about was the risk that 15 one of the legs would not clear. Another risk we talked 16 about was the transmission loss credit seemed to be 17 variable. In the early stages, he had already no 18 understanding of what the transmission loss credits would 19 be. But even at his best understanding of it, it was there 20 was a variable that he could not entirely predict. And 21 then there were risks from -- those are the risks that I 22 can recall right off the top of my head. 23 Q Did you explore with him in any greater detail 24 how his efforts to try to see what the transaction loss 25 credits might be at any particular time of the year, 0033 1 understanding that he did not have the ability to predict 2 them with perfection? Did he indicate to you whether or 3 not he had ever studied them in order to be able to get 4 close to that? 5 A Well, let me just correct one sort of premise of 6 your question. In this meeting with Dr. Chen, I would say 7 I asked fewer questions than most people. So there was 8 sort of a back-and-forth in the discussion in Dr. Chen 9 discussing, but I wouldn't say it was sort of me leading 10 the discussion. What I recall is that I received some data 11 on transmission loss credit rebates, and then he 12 subsequently received some data on retroactive rebates. 13 And as the spring went on and he gathered more information, 14 he felt like he had a better understanding, an improved 15 understanding of the transmission loss credits, but never a 16 very precise understanding of what it would be for any 17 particular day. 18 Q With respect to the retroactive credits that you 19 recall him describing, do you recall what he did with that 20 information or if he described it to you when he received 21 it? 22 A He did not. I do not recall any in-depth 23 discussion of how he analyzed that to try and get a better 24 understanding. 25 Q And do you have an understanding of when he 0034 1 received that retroactive data relative to June or July of 2 2010, how much time had passed before June or July of 2010, 3 if there was any time that passed between June or July of 4 2010 and his receiving of that retroactive data? 5 A I can't give you a precise or even an estimated 6 month when he received the retroactive data. My 7 recollection is that he received some information about 8 rebates, and then something like a month later he got the 9 retroactive information. Whether that was January and 10 February or May and June, I couldn't tell you. 11 Q Did you have an understanding of how long a 12 period of time these retroactive payments covered, whether 13 it was years, whether it was months? 14 A My recollection, it was several months. 15 MR. MC SWAIN: Steve, could we take a short 16 break now or in five? 17 MR. TABACKMAN: No, now is fine. 18 (Recess.) 19 BY MR. TABACKMAN: 20 Q What's your understanding of what a transmission 21 loss credit is? 22 A As I understand it, the transmission pricing is 23 done on an average or on a marginal basis, which sort of 24 overcalculates the amount of transmission loss, so that the 25 overcalculation that is then given back -- should be given 0035 1 back to somebody. There's no sort of logical or legal 2 person that it needs to go to. So they come up with some 3 allocation to give it back to somebody. 4 Q Do you recall -- you said, I believe in 5 paragraph 2 of your affidavit, you read the Commission's 6 orders regarding the transmission loss credits in UTC 7 transactions? 8 A Yes. 9 Q Did you come to an understanding of who was 10 getting them, getting transmission loss credits? 11 A The transmission loss credit, as I recall, 12 evolved over time. Originally, they were not being given 13 to the virtual traders, and then there was a change and 14 they were then shared with the virtual traders. 15 Q Do you recall what you read about why they were 16 given to the virtual traders? 17 A I believe the virtual traders were actually 18 paying for to reserve transmission capacity. 19 Q And transmission loss, you said it's a 20 transmission loss credit. Did you come to an understanding 21 of what a transmission loss is? 22 A When energy is transported from node to node, it 23 disappears, evaporates, dissipates. 24 MR. TABACKMAN: Let's mark this as Exhibit 6. 25 (Exhibit Wallace 6 identified.) 0036 1 BY MR. TABACKMAN: 2 Q I'm giving a copy to counsel. 3 Let me ask you, Mr. Wallace, before I ask you 4 about this, did you read Alan Chen's depositions? 5 A No, I did not. 6 Q Take a look at Exhibit 6. I just have a couple 7 of questions. 8 A Okay. 9 Q Just to identify this, Exhibit 6 is a five-page 10 document, although the last two pages simply have 11 confidentiality notices and addresses on them, ranging from 12 POW 4685 to 4689; is that correct? 13 A Correct. 14 Q It's a series of e-mails back and forth between 15 Alan Chen, spanning the period from August 5th, I believe 16 is the earliest one, through the top one on the first 17 page -- actually, there's also Chao Chen's is the latest of 18 them -- August 5th through August 18th of 2010; is that 19 correct? 20 A Yes. I believe Mr. Chao Chen is also cc'd on 21 some of these e-mails. 22 Q Correct. Looking down at the last e-mail from 23 Kevin Gates to Alan Chen that appears on number 4685, the 24 first page, if you would read that, do you recall the 25 subject of -- well, first of all, do you recall seeing this 0037 1 e-mail thread in particular? 2 A I may have. I do not recall. 3 Q Do you recall talking with Kevin Gates about the 4 subject of moving -- making money by moving electricity 5 around in a circle? 6 A No. 7 Q In preparation for your affidavit, did you ever 8 become aware of how much money was made or not made in the 9 months -- in the months where there was these transmission 10 loss credits, how much Powhatan made? Do you have any 11 sense of what the order of magnitude of that was? 12 A I do recall seeing figures for monthly profit 13 and loss similar to what we've seen here sort of in place, 14 but I have no -- as I sit here today, I couldn't quantify 15 that at all. 16 Q Did you come to have an understanding that for 17 at least those months without the TLC there would have been 18 a substantial loss, but that the TLC made it into a 19 substantial gain? Is that something that you recall 20 hearing in the course of your preparation? 21 MR. MC SWAIN: Can you specify what you're 22 referring to by "those months"? 23 BY MR. TABACKMAN: 24 Q I'm sorry. June and July in particular, but 25 also the months that are referenced here, we saw one on 0038 1 February where it showed a turnaround to a loss from a 2 profit, but specifically in the summer months when Powhatan 3 came into existence, which was on or about May 30th of 4 2010, and thereafter through June and July, do you recall 5 seeing numbers, the order of magnitude of the profits that 6 were made after TLC versus before the credit was given? 7 A I recall that the TLC pushed the profit and loss 8 statement from a loss to a gain. I wouldn't be comfortable 9 saying it was substantial, because I just don't have a 10 recollection of what those numbers were. 11 Q Do you recall it was a change in millions of 12 dollars versus hundreds of thousands of dollars versus tens 13 of thousands of dollars? 14 A I do not recall. 15 Q Do you recall whether you discussed that 16 subject, the degree of change as a result of the 17 transmission loss credit with Mr. Gates or with Dr. Chen? 18 A I believe at the meeting at Skadden, Arps with 19 Dr. Chen, that there were discussions of overall profit and 20 loss. The timing and scope of those I do not recall today. 21 MR. TABACKMAN: I'm going to have this marked as 22 Exhibit 7. 23 (Exhibit Wallace 7 identified.) 24 MR. TABACKMAN: I'm giving a copy to counsel. 25 THE WITNESS: Okay. 0039 1 BY MR. TABACKMAN: 2 Q Exhibit 7 bears Bates stamp numbers POW 4722 3 through 4725. Again, I will characterize it as an e-mail, 4 exchange of a series of e-mails back and forth between 5 Kevin Gates and Alan Chen, all of which appear to be dated 6 August 24th of 2010; is that correct? 7 A It's also Larry -- 8 Q Larry Eiben is cc'd on these, but the authors 9 are either Alan Chen or Kevin Gates, as I understand. 10 A Seems to be. 11 Q In your discussions with Dr. Chen or with 12 Mr. Gates, did you have an understanding of a change in 13 strategy that occurred as a result of a loss that was 14 suffered? 15 A Yes. 16 Q What's your recollection? 17 A That there had been a significant loss, I 18 believe, on May 30th and that after that trade Dr. Chen 19 changed his trading strategy. I can't really say exactly 20 what the change was after that. I don't recall. 21 Q Looking at this e-mail -- I didn't ask you 22 this -- do you know whether or not you've seen this e-mail 23 exchange before? 24 A If it's in the package of materials that counsel 25 provided to me I have seen it, but I don't recall it 0040 1 specifically. 2 Q Do you recall discussing the subject that is in 3 the latest of the e-mails that appear, the top one on the 4 first page where Dr. Chen says "before 6/1, we didn't have 5 any fully hedged paired trades"? Do you recall discussing 6 what the difference was between what he had before 6/1 and 7 these fully hedged paired trades? 8 A I know we did discuss -- well, it was discussed 9 at that meeting at the offices of Skadden, Arps. I'm 10 drawing a blank on exactly what the change was. 11 Q Do you know what Dr. Chen means when he refers 12 to "fully hedged paired trades"? 13 A I'm not sure I do understand exactly what he 14 means. I can tell you what I believed it meant. 15 Q What did you understand it to mean? Is it a 16 term that you've seen before, "fully hedged paired trades," 17 or heard before? 18 A Yes, I've heard that term before. I've seen it 19 in, you know, documents, I believe, in the -- but I believe 20 it would be trades involving two nodes where it was 21 basically the terms going in opposite directions, not 22 identical but very similar. 23 Q Let's see if I can just -- again, does it 24 refresh your recollection that as you talk about having 25 volume, that in fully hedged paired trades, the same volume 0041 1 would be going from one node to another node and then 2 back -- and then in reverse at the same time of day? 3 A I just can't recall at this point. 4 Q Okay. Do you recall in the course of your 5 preparation discussing or reading anything about how often 6 this risk of a leg not clearing actually occurred during 7 the time that Powhatan was in existence? 8 A My recollection is that there were no instances 9 of a leg not clearing during that time frame. 10 Q Do you recall reading or discussing how often 11 the TLC, the transmission loss credit, did not cover or 12 exceed all of the other costs that were involved in the 13 transaction? 14 A No, I don't recall a discussion on that. 15 Q Looking at page 2 of Exhibit 7, paragraph number 16 2, if you would read that over and see if that refreshes 17 your recollection on any discussions you had on that topic 18 about when they lost money despite the TLC and when they 19 made money. 20 A Can you tell me again which -- 21 Q There's a paragraph that begins on the second 22 line from the top and has the number "2" next to it and 23 goes all the way down to where the "3" is. 24 A Okay. I see what's written here. It does not 25 refresh my recollection of any other understanding of 0042 1 specific dates. 2 Q Okay. How about of the subject of how often it 3 occurred that there was either slight losses or slight 4 gains despite the TLC? 5 A No, it doesn't refresh my recollection. 6 Q Did you have an understanding of the 7 transactions that for most -- except for a certain number 8 of dates, a fairly limited number, my characterization 9 based on that e-mail, that on most other dates, the TLC 10 more than covered all the other costs? 11 A It was my understanding that on an aggregate 12 basis, on sort of a month-to-month basis, it covered the 13 cost, but I don't believe I had an understanding on a 14 day-to-day basis of how consistent that was. 15 Q Going back to your affidavit, Exhibit 1, it 16 describes the things that you reviewed and says that you 17 reviewed various materials, including, and you describe 18 documents. 19 Other than the documents that are described in 20 that paragraph, do you recall reading anything else? 21 "Including" is a word that could cover a broad array of 22 things. I'm trying to get a sense of what else it might 23 include. 24 A Sure. I recall reviewing some of the, I will 25 call them, tariff decisions dealing with PJM, some -- 0043 1 Q Excuse me. Would that come under the "various 2 FERC decisions and rulemaking releases dealing with up-to 3 congestion transactions"? 4 A Right. And I think there's 680 or something 5 where they adopt Rule 10b and Rule 10b-5. 6 Q Okay. 7 A Very early on, just sort of browsing through 8 various documents on the FERC Web site, looking for 9 something that might help me better understand the energy 10 markets. So I'm sure I saw different things that I don't 11 recall right now. 12 Q In terms of documents that discuss the facts of 13 this investigation, the transactions, are there other 14 documents that you recall that are not described in this 15 paragraph that are not encompassed by that description, and 16 I will include all of the exhibits that may have been in 17 the Kevin Gates deposition. You saw those, although you 18 may not be able to identify particular ones; is that right? 19 A Yes. 20 Q You did not see the Chen depositions? 21 A No. 22 Q Did you ask for them? 23 A No. 24 Q But other than -- and you reviewed Dr. Craig 25 Pirrong's affidavit submitted by Skadden as a part of its 0044 1 submission made on behalf of Dr. Chen? 2 A Uh-huh. 3 Q Is that right? 4 A Yes. 5 Q I take it you read the rest of that submission 6 as well? 7 A Correct. 8 Q Again, other documents that you can specifically 9 recall having seen or not seen that describe the facts of 10 these transactions at issue? 11 A Recently, in connection with the Staff's fourth 12 data request, I went back and looked at the e-mails and 13 other documents that had been provided to me. But given 14 the sort of date range on the fourth data request, I 15 didn't -- I was focusing on things that were produced and 16 delivered to Powhatan between two date ranges, and I can't 17 recall whether there are any other documents that I saw 18 that might have been outside that date range. But 19 certainly, the items that were the main portion of my sort 20 of factual background understanding of this case are the 21 ones described in paragraph 2. 22 Q Okay. Did you look at, for example, 23 spreadsheets or actual transactional data that may have 24 gone back from Dr. Chen to the Gates's? 25 A I don't believe I did. I mean, I saw the 0045 1 e-mails. I don't believe the e-mails that I had had any 2 attachments. So I don't think I would have seen the actual 3 data being passed back and forth. 4 Q The data requests -- can I mark this, or is this 5 your copy? 6 MR. MC SWAIN: Sure. 7 MR. TABACKMAN: If we could have this marked as 8 Exhibit 8, please. 9 (Exhibit Wallace 8 identified.) 10 MR. MC SWAIN: I have it on e-mail. So you 11 don't need to send me another one. 12 BY MR. TABACKMAN: 13 Q Is that the document you're referring to as the 14 fourth data request? 15 A Yes, it is. 16 Q You have the only copy at this moment, but the 17 second paragraph, I think number 22, makes reference to 18 looking for documents from you -- "documents, 19 communications, and analysis that Mr. Richard Wallace 20 considered or were relied upon in developing and drafting 21 his affidavit of October 21, 2011." 22 You just made reference to things that may have 23 fallen outside of a certain date range, and I wanted to 24 understand what you were referring to? 25 A In the preface paragraph to the data request, it 0046 1 says in bold "Unless otherwise indicated, the documents 2 sought by these data requests are those created (by anyone) 3 or received by Powhatan between June 1, 2007 and August 1, 4 2010." 5 Q Okay. 6 A And I don't see any other sort of overriding 7 date ranges in that request. 8 Q So you were trying to recall whether or not you 9 saw documents that may have gone back and forth -- that may 10 have met that description that you just read outside of 11 that date range? 12 A Right. I don't recall any, but I can't say -- I 13 would hate to testify that there were none. 14 Q Okay. That's fair. Thank you. Looking back at 15 your affidavit, Exhibit 1, paragraph 5, it says that you 16 were the vice president and chief counsel at FINRA's market 17 regulation department, from 2001 to 2008. 18 A Yes. 19 Q Is there a separate enforcement department? 20 A Yes, there is. 21 Q What is the relationship between those? 22 A They operate in parallel. The enforcement 23 division can bring disciplinary actions and settle 24 disciplinary actions and appeal them. The market 25 regulation department brings its own disciplinary actions 0047 1 and makes its own call on settling, and somewhere up the 2 chain of command they're supposed to be coordinated. 3 Q You describe a number of different kinds of 4 cases beginning on page 4. I want to make sure that we 5 understand exactly the kind of case you're talking about. 6 "Rebates for Reporting Trade Data in the Equities Markets." 7 A Which paragraph are you -- 8 Q I'm sorry. On page 4 there's a heading just 9 before paragraph 16. 10 A Okay. Right. 11 Q And it talks about -- it says "Rebates for 12 Reporting Trade Data in the Equities Markets." I take it 13 these are, again, similar kinds of circumstances where 14 there was some money flowing back outside of what we can 15 call the intrinsic spread of the sale price and the 16 purchase price of whatever it was that was being traded? 17 A Correct. 18 Q And these -- the reports for trade data in the 19 equities markets, rebates for reporting trade data in the 20 equities markets, what did those cases involve? 21 MR. MC SWAIN: I think we're getting a little 22 bit beyond the scope, but I think you can answer that. 23 MR. TABACKMAN: I'm trying to understand the 24 facts generally. 25 THE WITNESS: The stock exchanges sold data on 0048 1 transactions to new services, Bloomberg's, Yahoo! Wall 2 Street Journal, et cetera, and they would earn hundreds of 3 millions of dollars a year. Beginning in the '90s or 4 around 2000 or something like that, they started sharing 5 some of that money back to participants in the trades. 6 Originally, it was on a trade reported basis. So these 7 were trade data rebates that could go back and would, you 8 know, constitute a certain amount of money per trade. 9 BY MR. TABACKMAN: 10 Q So that -- and were these the kinds of things 11 where people had to have a certain number of trades to get 12 the rebate? 13 A In some of the iterations of these rebates, 14 there were ceilings and floors and thresholds where the 15 rebate rates would change. 16 Q What you described as money going back from the 17 reporting agencies, Wall Street Journal, Bloomberg, back to 18 the market; correct? 19 A Correct. 20 Q I think I understood you. You were saying the 21 market would share that with the traders, whatever discount 22 they got? 23 A The firms. 24 Q The firms that did the trading? 25 A Correct. 0049 1 Q And if I understand your affidavit, there were 2 no cases brought with respect to those rebates, people who 3 received those rebates? 4 MR. MC SWAIN: "Cases brought," meaning what? 5 BY MR. TABACKMAN: 6 Q There was no enforcement action taken by either 7 the SEC or FINRA regarding the parties who received those 8 rebates? 9 A These rebates were rules that were approved by 10 the -- first by the SROs, the stock exchanges, and their 11 rules were approved by the Securities and Exchange 12 Commission. There was 1 case which I have described in 13 there, which is the Amanet case, which did involve a firm 14 engaging in wash sales to try and change the threshold that 15 they would meet to get some forms of rebates. 16 Q Where is the Amanet case discussed in here? 17 A I may have misspoken. The Amanet case, which I 18 thought involved a firm called MarketXT which traded in the 19 NASDAQ market and the -- a case was brought against them 20 for engaging in wash sales. 21 Q Is Amanet a case that, if it had been discussed, 22 would fall under these rebates for reporting trade data in 23 the equities markets-type cases? Generally, is that what 24 those rebates involved in that case? 25 A Yes. 0050 1 Q Were you involved in any way in the Amanet case, 2 in the action that was taken -- I guess you were at FINRA 3 when that case was brought by the Commission? 4 A Correct. I was aware of the case. I did not 5 have a, you know, substantive role in how it was decided. 6 Q Have you read the Commission's decision in that 7 case in the course of preparing your affidavit? 8 A Yes. 9 Q You mentioned that it was mentioned here. Is 10 that something that you meant to have in your affidavit, 11 the Amanet case? 12 A I know we had considered it and tried to 13 determine whether it was on point or not. 14 Q When you say "we," who are you referring to? 15 A Both with Miriam Ahmed, the associate at Foley & 16 Lardner, and with counsel. 17 Q I take it when you said earlier that you 18 discussed it in here, you thought that you had mentioned 19 Amanet in your report, in your affidavit? 20 A That was my impression this morning. 21 Q I didn't recall seeing it. That's why I was 22 asking you to point out where it was, because I could have 23 missed it. 24 But you don't recall intentionally deciding to 25 leave it out? 0051 1 A At this point I know it is something that we 2 discussed, and since I thought it was in there a few 3 minutes ago, I'm drawing a blank as to why or what the 4 discussions were as to not including it. 5 Q If we could look at paragraph 44, you reference 6 in that paragraph an article by three people, one of whom 7 is Stewart Mayhew, who, I believe, you say at the time the 8 paper was published, was the deputy chief economist of the 9 SEC. 10 A Correct. 11 Q And do you know Mr. Mayhew? 12 A I do. 13 Q The article that's -- the title of it is in the 14 document here, your affidavit. It's called "Ex-dividend 15 Arbitrage in Options Markets." And you describe -- and I'm 16 not going to go into a discussion of the substance of the 17 article. I just was wondering, was this -- strike that. 18 You have a quote in paragraph 45 that 19 says "'Because'" -- and I'm quoting the affidavit that, in 20 turn, quotes from the paper. And it says "'Because the two 21 trades are exactly offsetting and executed at the same 22 price, the initial position has zero risk and requires no 23 capital.'" And it cites the paper. 24 A Uh-huh. 25 Q And it's talking about traders trading options 0052 1 back and forth. That's the general subject matter of the 2 article. 3 A Right. 4 Q Did the article, this paper, endorse that kind 5 of trading that you describe in your affidavit as an 6 appropriate kind of trading, or did it -- I mean, you 7 described what it talks about and how it describes the 8 trades. Did the article take any position on those trades 9 in terms of their legitimacy, whether they should be the 10 subject of an enforcement action? I haven't seen the 11 article. 12 A No, it does not take a position that there 13 should be an enforcement action. 14 Q What conclusion -- I mean, from the description, 15 and Mr. Mayhew's position, he was saying that he was 16 endorsing that kind of trade or rebates based on that kind 17 of -- as I just described reading from the quote? 18 A No, it is endorsing. I think it's more of a 19 descriptive piece describing what the practice is and its 20 impact on the markets. 21 Q And do you recall what the article said about 22 the impact of that practice on the market? 23 A I do not recall the impact, what it described as 24 the impact on the market. 25 Q Did it generally describe -- do you recall 0053 1 whether it described it as positive or negative impact on 2 the market? 3 A I do not recall a description of it as having a 4 negative impact on the market. 5 Q What was the context in which this article 6 was -- or this paper was published, the purpose of it, as 7 they described it? 8 A I don't recall. 9 MR. TABACKMAN: We can go off the record for a 10 minute. 11 (A discussion was held off the record.) 12 BY MR. TABACKMAN: 13 Q Mr. Wallace, I just need to remind you you're 14 still under oath. 15 Since your meeting in October 2011 with Kevin 16 Gates, have you discussed this case, your affidavit with 17 anyone from that time up until today? 18 A My affidavit or the case? 19 Q Strike that. Let me modify that. Anything have 20 to do with the subject matter of -- I'm sorry. There was 21 more than one question. Let me withdraw that question and 22 ask you a different question. 23 Let me have marked as -- 24 MR. MC SWAIN: I assume you're talking about 25 discussions other than with me? 0054 1 BY MR. TABACKMAN: 2 Q Yeah, other than discussions with Mr. McSwain or 3 one of the other lawyers in the case, have you had any 4 discussions about this matter with Dr. Chen, Mr. Gates, any 5 of the other -- anybody else from Powhatan? 6 A No. 7 MR. TABACKMAN: Let me have this marked as 8 Exhibit 9. 9 (Exhibit Wallace 9 identified.) 10 BY MR. TABACKMAN: 11 Q I'm giving a copy to counsel. 12 Again, I'm not going to ask you substantive 13 questions about this document. Do you recognize Exhibit 9? 14 A Yes, I do. 15 Q What is it? 16 A This is a redacted hearing panel decision issued 17 by the NASD's office of hearing officers. 18 Q Okay. It's styled "DEPARTMENT OF MARKET 19 REGULATION versus Respondent," and the respondent's name 20 has been redacted? 21 A Correct. 22 Q NASD is the predecessor to FINRA; correct? 23 A Correct. It stands for National Association of 24 Securities Dealers. 25 Q And you were the vice president and chief 0055 1 counsel of the department of market regulation when this 2 case was brought? 3 A Correct. 4 Q And did you authorize bringing this case against 5 Mr. Kellogg? Did you approve bringing this case against 6 Mr. Kellogg? 7 A Yes. 8 Q So before the hearing panel ruled, you thought 9 what he had done was unlawful? 10 A Correct. 11 Q Was this decision of the hearing panel appealed? 12 A No. 13 Q So this was the final decision in the case? 14 A Correct. 15 Q Is there a procedure for appealing hearing panel 16 decisions? 17 A There is. 18 Q Who would that be appealed to if you wanted to 19 appeal it? 20 A It would be appealed to the National 21 Adjudicatory Council of now NASD, then FINRA. 22 MR. TABACKMAN: That's all I have on that. I 23 have no other questions. 24 MR. MC SWAIN: I have a couple of quick 25 questions. 0056 1 EXAMINATION 2 BY MR. MC SWAIN: 3 Q Are you familiar with the term "home run trading 4 strategy" as that term has been used in the context of this 5 case? 6 A Yes. 7 Q Can you briefly describe, just briefly, what 8 that is? 9 A If you put on a paired transaction and one leg 10 did not clear, there is a potential for making very large 11 profit or a loss but potential for a very large profit on 12 the remaining leg of the paired transaction. 13 Q And did Dr. Chen discuss that strategy in the 14 meeting at the Skadden offices that you testified about 15 that occurred, I believe, in September of 2011? 16 A Yes. I'm not sure he used the term "home run." 17 He may have. But he did discuss this possibility of making 18 profits if one leg cleared and the other one didn't. 19 Q And did he say that he used that trading 20 strategy specifically in the summer of 2010? 21 A Yes. 22 MR. MC SWAIN: Okay. That's all I have. 23 FURTHER EXAMINATION 24 BY MR. TABACKMAN: 25 Q I have a couple of questions on that. Do you 0057 1 recall who used the term "home run trading strategy," how 2 that first came to your attention? 3 A I do not. 4 Q Do you recall seeing it in any of the documents, 5 the contemporaneous documents that you reviewed? 6 A I don't have a recollection of whether I did or 7 didn't see that. 8 Q And your understanding of Dr. Chen's pursuing 9 this home run trading strategy, I take it he described 10 pursuing a strategy of making a lot of money if one leg 11 didn't clear? 12 A Yes. 13 Q Is that what you mean by he subscribed to that 14 strategy? 15 A Yes. 16 Q In the course of this meeting, did you explore 17 with Dr. Chen whether he -- or did anyone, not just you, 18 but was it explored in the course of this meeting whether 19 or not Dr. Chen intentionally set up trades in the hopes 20 that there would be a leg not cleared or if -- strike that. 21 Let me set up two alternatives. Was that a 22 strategy that he pursued as something that he wanted to 23 have happen, that is, setting up so that the leg wouldn't 24 clear, or did he always try to have both legs clear but 25 that he had set up trades so that if one didn't he would 0058 1 make money rather than lose money, if that's a distinction 2 that you recall? 3 A He described trades in which the up-to 4 congestion limit on the two trades was not identical in 5 that there was a higher congestion limit on one leg of the 6 trade than on the other and that he did not always put in 7 for the highest up-to congestion limit possible, which I 8 believe is $50. Some were at 15, some were at 25, some 9 were at other levels, less than the maximum congestion, 10 though. 11 Q And it was your understanding -- what was your 12 understanding of why he did that? 13 A That that would increase the likelihood or the 14 possibility that one leg would not clear. 15 Q And is it your understanding that Dr. Chen 16 affirmatively tried to make -- structure his bids, these 17 limits as you refer to them, in a way to try to make that 18 happen, that is, intentionally looking to have one leg not 19 clear? 20 A At least in some trades, and I'm not sure if it 21 would be in all trades, but at least in some trades they 22 were structured to increase the possibility that one leg 23 would not clear. 24 Q In the course of this meeting with Dr. Chen, did 25 you come to have any understanding of whether Dr. Chen had 0059 1 made any studies of these nodes to determine when he made 2 bids less than $50, the likelihood that they would or would 3 not clear at a lower amount? 4 A I do not recall him discussing any studies or, 5 you know, efforts to determine the likelihood of that. I 6 don't recall that. 7 Q So if I understand your discussion, your 8 take-away from this is that on some occasions he bid less 9 than $50; is that right? 10 A Correct. 11 Q And by bidding less than $50, he didn't minimize 12 in terms of the cost the possibility of it not clearing? 13 A Correct. 14 Q $50 would be the highest he could ever go to try 15 to make it clear? He couldn't go any higher than that? 16 A Correct. 17 Q But you don't know whether or not, for example, 18 when he put in his $35 bid, if he had looked at the market 19 over a course of years and seen that at that particular 20 node any bid over -- I'm picking a number -- over dollar 10 21 always cleared or almost always cleared? There wasn't any 22 discussion about that, was there? 23 A I don't recall any discussion about that. 24 MR. TABACKMAN: Thank you. I don't have any 25 further questions. Mr. Wallace, thank you so much. 0060 1 THE WITNESS: You're welcome. 2 MR. TABACKMAN: I appreciate your time. 3 (Whereupon, at 12:13 p.m., the deposition was 4 concluded.) 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 0061 1 C O N T E N T S 2 3 WITNESS EXAMINATION 4 RICHARD G. WALLACE 5 by Mr. Tabackman 4, 56 6 by Mr. McSwain 56 7 8 9 10 E X H I B I T S 11 12 EXHIBIT NUMBER IDENTIFIED 13 14 Exhibit Wallace 1 7 15 Exhibit Wallace 2 22 16 Exhibit Wallace 3 24 17 Exhibit Wallace 4 28 18 Exhibit Wallace 5 30 19 Exhibit Wallace 6 35 20 Exhibit Wallace 7 38 21 Exhibit Wallace 8 45 22 Exhibit Wallace 9 54 23 24 25