UPDATE 2-Citadel lawyers seek to halt Teza business

(Adds additional defense closing arguments)

By James B. Kelleher

CHICAGO Oct 9 (Reuters) - Calling Teza Technologies a "veritable pirate ship of illegal activity," lawyers for the hedge fund Citadel Investment Group urged a judge here on Friday to prohibit the high-frequency trading startup and its two founders from doing business for at least nine months.

During final arguments in the preliminary injunction portion of Citadel's civil lawsuit against Teza, lawyers for the Chicago investment giant said the defendants, former Citadel executives Mikhail Malyshev and Jace Kohlmeier, had violated their promise not to compete against Citadel or solicit its employees when they "surreptitiously" set up the new company less than six months after leaving Citadel.

The trial has garnered attention because of the small window it has opened on the secretive, lucrative and fast-growing world of high-frequency trading and the math-savvy programmers who are its key players .

Today's closing arguments drew Kenneth Griffin, Citadel's founder and head, into the packed courtroom, where company lawyers claimed the proceedings were being monitored by the "entire financial community" to see if non-compete agreements the two men allegedly violated still had any meaning.

Griffin normal avoids publicity and the trial has thrust his powerful investment empire into a spotlight it typically shuns. He declined to answer any questions from reporters and left the courtroom after Citadel lawyers rested their case.

In their closing arguments, lawyers for Teza insisted the startup's actions to date had not injured Citadel in any way.

"We're not engaged in the business they're in," Teza's lead lawyer said. "We want to be, but we're not."

They said Teza had not begun working on what they maintain is the core of the business: developing the analytics -- or so-called "alpha signals" -- that would allow programmers to write algorithms that turn computers into super traders of financial instruments.

"They're not being hurt," defense lawyers said of Citadel. But they warned that Teza would be "effectively destroyed before it gets off the ground" if the injunction was granted.

Citadel, they said, had "used this litigation like a bludgeon" to punish former employees by unleashing "an army of lawyers to crush two guys who had the temerity" to leave Citadel and start a business on their own.

Citadel's lawyers claim Teza is a competitive enterprise that has been recruiting programmers, building databases, constructing super-fast trading engines and developing trading strategies in an effort to get into the high-frequency, low-latency business - a business based on the idea that properly programmed computers can predict the price of a financial instrument one second in the future and automatically trade on that information.

It's a business where code is king and milliseconds are the difference between profit and loss.

Teza made headlines this summer when one of its hires, a former Goldman Sachs Group (GS.N) computer programmer named Sergey Aleynikov, was arrested and charged with stealing secrets from the investment bank. Aleynikov denied the charges but Teza fired him.

Citadel subsequently filed a lawsuit against Teza, claiming that Malyshev and Kohlmeier had violated their non-compete clauses by starting the company.

In a separate but related arbitration proceeding, Citadel is seeking $300 million from each of Teza's two founders.

In their arguments on Friday, Citadel's lawyers asked the judge hearing the case to sanction Malyshev for violating a court order to preserve evidence related to the case and then lying about it on the stand.

They suggested the judge fine Malyshev - who listened to much of Friday's arguments with his head bowed - one-third of his compensation at Citadel last year. That exact figure is under seal but reported to be in excess of $100 million.

"A fine of even one week (of last year's pay) would be significantly in excess of seven figures," the lead lawyer for Citadel argued.

Malyshev's attorneys do not deny their client erased files from a personal computer after the parties agreed to a document preservation order. But they insist he is addicted to hard-core pornography and wanted to avoid the discovery of embarrassing content downloaded from the Internet..

A ruling in the trial is expected next week.

(Reporting by James B. Kelleher)