Whistleblower Angered by SEC's Split of $27 Million Award

September 27, 2022

Presented in today's blog is a mess that started with a 2010 FINRA Arbitration Award, then moved on to the filing of an SEC whistleblower claim, then got embroiled in a dispute over whether the ensuing $27 million SEC Whistleblower Award should be divided two ways, and then prompted a Petition against the SEC's rendering of the Award. On appeal, the federal circuit court's Opinion stated that the whistleblower presented "an argument so obtuse as to be insulting." Ouch! 

2010 FINRA Arbitration Award

In the 1990s, Michael Johnston, Michael Mittman, and John Arnold purportedly established a financial advisory team at Citi Smith Barney (a Citigroup, Inc. subsidiary) that was known as the "Johnston Team," for which Johnston managed client relations and Arnold and Mittman were junior members. In a FINRA Arbitration Statement of Claim filed in August 2008, Michael A. Johnston, John J. Arnold, and Michael J. Mittman, Claimants/Counter-Respondents, v. Citigroup Global Markets, Inc., Respondent/Counter-Claimant (FINRA Arbitration Award 08-02896 / June 21, 2010)
https://www.finra.org/sites/default/files/aao_documents/08-02896-Award-FINRA-20100621.pdf, associated person Claimants Johnston, Arnold, and Mittman asserted:

(1) Constructive termination of Johnston Group's employment; (2) Violation of California Business and Professions Code Prohibiting 'Unlawful, Unfair or Fraudulent business practices; (3) Fraudulent misrepresentations or omissions; (4) Negligent misrepresentation; (5) Breach of contract and implied covenant of good faith and fair dealing; (8) Intentional Interference with prospective business advantage; (7) Violation of provisions of the California Labor Code by withholding the Johnston Group's wages and benefits; (8) Violation of California Business and Professions Code Section 17200 a second time by withholding benefits, earned and deferred compensation from the Johnston Group; (9) Accounting of all sums due to the Johnston Group; and (10) Indemnification of the Johnston Group by Citigroup per California Labor Code for ell attorneys' fees and expenses arising from the recommendation and sale of MAT and Falcon Strategies. 

As further alleged in the FINRA Award:

[T]he causes of action relate to the Johnston Group's employment with Citigroup, the losses incurred by the Johnston Group's clients as a result of investment in two Cittgroup funds, MAT and Falcon Strategies, and Claimants' departure from Citigroup to seek employment with another broker-dealer firm. 

Claimants sought $10 million in compensatory damages, punitive damages, an accounting of all sums due to the Johnston Group, wages and benefits wrongfully withheld, fees, costs, and expenses. Respondent Citigroup generally denied the allegations, asserted affirmative defenses, and filed a Counterclaim asserting breach of contract attendant to Promissory Notes and Forgivable Loan Agreements. 

The FINRA Panel found Respondent Citigroup liable and ordered it to pay to Claimants $94,566.24 plus interest as indemnification. Further, the Panel found Claimants liable and ordered them to pay to Respondent compensatory damages with interest of $276,418.50 (Johnston); $12,385.50 (Mittman); and $20,839 (Arnold). The Panel declined to grant any expungements of the matter from Claimants' industry records.

The Independent Back-Tests

A funny thing happened while the Johnston Team was preparing for its FINRA Arbitration. Let's pick up the story as it is told in Michael Johnston, Petitioner, v. Securities and Exchange Commission, Respondent / Michael Mittman, Invervenor (Opinion, United States Court of Appeals for the District of Columbia Circuit, No. 21-1132 / September 23, 2022)

In 2008, the Johnston Team brought an arbitration proceeding against Citigroup before the Financial Industry Regulatory Authority. The arbitration concerned approximately $3 billion in investments that Johnston managed in Citigroup's so-called "ASTA/MAT" funds and its "Falcon" Strategy funds. These funds collapsed during the 2008 financial crisis. Johnston continued to lead the Team throughout the arbitration. He retained an attorney, Michael Blumenfeld, to represent the Team. 

As Johnston prepared for the arbitration, he claims he discovered, without any input from Mittman or Arnold, that Citigroup made misrepresentations about its "back-tests" -- tests conducted to verify Citi's risk assessment of the ASTA/MAT and Falcon funds using historical investment data. 

In July 2010, after making this discovery, the Johnston Team submitted a 25-page report to the SEC detailing the problem. Mittman and Johnston were both present at a meeting on July 26 and 27 in which the two presented the findings of the Team's independent back-tests. 

The SEC then brought an enforcement action against Citigroup Alternative Investments, LLC and Citigroup Global Markets, Inc., which resulted in a settlement of $189 million. See In the Matter of Citigroup Alternative Invs. LLC & Citigroup Glob. Markets Inc., Securities and Exchange Commission Release No. 4174 (Aug. 17, 2015). Following the settlement order, the SEC invited whistleblowers to file claims for an award by issuing Notice of Covered Action No. 2015- 92. Johnston and Mittman each submitted a timely claim, although Johnston's claim stated he was submitting his on behalf of the Johnston Team as a whole.

In 2020, the SEC's Claims Review Staff issued its Preliminary Order, which recommended that the Commission grant Johnston and Mittman a joint whistleblower award in the amount of $18.9 million - 10 percent of the fine the Commission collected - to be divided equally between the two. The recommendation was supported by the affidavit of a staff attorney, Olivia Zach, who had been the primary SEC point of contact with the Johnston Team. As Johnston notes, her affidavit stated: "While we had significantly more contact with Michael Johnston, we have no insight into how much Michael Mittman had contributed to the materials provided by Johnston." As a result, the SEC viewed the two men as having provided the original information jointly. 

at Pages 3 - 4 of the DCCir Opinion 

SIDE BAR: In the Matter of Citigroup Alternative Investments LLC and Citigroup Global Markets Inc., Respondents (SEC Order Instituting Proceedings and Imposing Sanctions ("OIP"); '34 Act Rel. No., 75710; Invest. Adv. Act Rel. No. 4174; Admin. Proc. File No. 3-16757 / August 17, 2015)
https://www.sec.gov/litigation/admin/2015/33-9893.pdf As alleged in the "Summary" of the OIP:
These proceedings concern material misstatements and omissions made by Respondents between 2002 and 2007 in the offer and sale of securities in two now-defunct hedge funds-the ASTA and MAT funds ("ASTA/MAT") and the Falcon Strategies funds ("Falcon"). The ASTA/MAT and Falcon funds were recommended and sold by two groups of individuals, the "financial advisers" of Smith Barney and the "private bankers" of Citigroup Private Bank (together, the "financial advisers"), to their advisory clients. The financial advisers were associated with respondent CGMI. Both funds were managed by respondent CAI, which acted through its employees, including an employee who had a primary role in creating the funds and serving as the funds' manager during the relevant time period (the "fund manager"). Respondents raised approximately $2.898 billion from approximately 4,000 investors in ASTA/MAT and Falcon. In 2008, both funds collapsed resulting in billions of dollars in losses. 

From 2002 through 2008 (the "relevant period"), financial advisers and the fund manager misrepresented the funds' risks and performance to advisory clients, who were told that the investments were "safe," "low-risk," "bond substitutes" and suitable for traditional bond investors, despite statements in marketing documents that the funds should not be viewed as a bond substitute. In addition, while the risk of principal loss was disclosed in written materials provided to clients, certain financial advisers and the fund manager orally minimized the significant risk of loss resulting from, among other things, the funds' investment strategy and use of leverage. Investors were also told that the biggest risk facing ASTA/MAT was the adoption of a flat income tax by the federal government. Financial advisers encouraged many of their advisory clients to sell portions of their bond portfolios in order to invest in the funds. In late 2007, financial advisers and the fund manager continued to offer and sell Falcon as a safe, low-risk investment, even though both funds- the Falcon fund was 20 percent invested in the ASTA/MAT fund-began experiencing increased margin calls and liquidity problems in the second half of 2007 that continued until the funds collapsed. 

Moreover, the fund manager was involved in virtually all fund-related communications with the financial advisers and investors. The fund manager and the fund manager's staff were responsible for drafting and reviewing offering materials for the funds, crafting sales pitches to investors, training CAI sales personnel (who, in turn, were responsible for marketing the funds to the financial advisers), drafting quarterly investor reports, disclosing interim fund performance, and managing the funds themselves. Furthermore, throughout the fund offerings and fund operations, the fund manager and the fund manager's staff at CAI met with prospective investors and responded directly to inquiries from the financial advisers concerning the funds without sufficient oversight governing those oral communications. The fund manager and his staff at CAI had significant influence over the dissemination of information relating to the funds without review or oversight, including information relating to the funds' risks and performance. CAI failed to implement a system in which the fund manager's authority was checked adequately or to ensure that the fund manager's communications with investors and financial advisers concerning the ASTA/MAT and Falcon funds were accurate and not misleading. 

Waddya Mean "Joint"?

By way of recap, the Johnston Team filed a FINRA Arbitration Statement of Claim in 2008, which prompted a likely disappointing 2010 FINRA Arbitration Award. Notwithstanding the lousy payday elicited from the arbitrators, the three team members seem to have hit pay-dirt with their SEC Whistleblower Claim -- or, at least Johnston and Mittman ultimately shared $27 million in an SEC Whistleblower Award. Except that's not quite how Johnston seems to have viewed things:

Johnston filed multiple objections to the Preliminary Order, introducing affidavits from Arnold and Blumenfeld stating that he alone was responsible for discovering the misrepresentations about the back-tests - the only original information the Johnston Team provided. Mittman did not object to the recommendation, add evidence to the record, or represent that he and Johnston were joint whistleblowers. 

In 2021, the SEC issued its Final Order, granting Johnston and Mittman, as joint whistleblowers, 15 percent of the sanctions, or $27 million, to be divided equally. The Commission rejected Johnston's contention that the Johnston Team had made an oral agreement setting out the division of any award among the three members based upon their "financial contributions and non-financial contributions," which Johnston suggested entitled him to approximately 90% of any award. 

The Commission relied upon three facts to determine that Johnston and Mittman were joint whistleblowers: (1) The two men together attended the July 2010 meeting with the SEC as members of a single team and represented by a single attorney; (2) their counsel later submitted a letter stating "I am legal counsel to Messrs. Michael Johnston, Michael Mittman, and John Arnold (the 'Johnston Team')" and characterizing the "original research and independent analysis" submitted to the Commission as "developed by the Johnston Team"; and (3) at no point during the investigation did any member of the Team or its counsel delineate which information each member of the Team had provided.

at Pages 4 - 5 of the DCCir Opinion

Johnston Petitions DCCir

In 2021, Johnston petitioned DCCir for review of the SEC Order granting him a whistleblower award for providing original information leading to a successful enforcement action against Citigroup, Inc. Pointedly, Johnston objected to the SEC's determination to treat he and Mittman as joint whistleblowers and equally dividing the Award. DCCir summarized Johnston four arguments in favor of vacating the SEC Award to Mittman:

[(1)] By ignoring the contract between the two and splitting the award evenly, the SEC overstepped its statutory authority; (2) the SEC should have applied the law of joint ventures to determine whether he and Mittman were acting jointly as whistleblowers; (3) having provided no original information to the Commission, Mittman was not eligible for an award; and (4) because the SEC ignored unrefuted evidence that he and Mittman were not joint whistleblowers, the decision to treat them as such was arbitrary and capricious. 

at Page 5 of the DCCir Opinion

It Don't "Amount" To Nothing

In response to Johnston's Petition, Mittman argued that DCCir lacked jurisdiction because the Dodd Frank Act precluded judicial review of the amount of an SEC Whistleblower Award. The SEC argued that DCCir could consider Mittman's eligibility for the Award but only that issue. In resolving the competing arguments as to its jurisdiction pertaining to the SEC Award, the Court found in pertinent part that:

We see that three of the arguments Johnston raises directly challenge the division of the award, not Mittman's eligibility for an award: (1) The law of joint ventures bars Mittman from receiving an equal award, a component of the first issue Johnston raises, namely, whether the SEC should have applied the law of joint ventures in its decision; (2) the SEC ignored the parties' contract in deciding to split the award evenly between Mittman and himself, the remainder of the first issue Johnston raises; (3) the authority Congress delegated to the SEC to issue a whistleblower award does not include the power to interpret an agreement between parties to split the award, the second issue Johnston raises. Because these arguments challenge the percentage of the award Mittman should receive, rather than his eligibility for an award, we do not have jurisdiction to consider them. On the other hand, Johnston is correct, as the SEC concedes, that the remainder of Johnston's arguments go to Mittman's eligibility. Therefore, we deny in part and grant in part Mittman's motion to dismiss Johnston's petition, and do not consider Johnston's arguments going to the amount of his award relative to Mittman's. 

at Page 8 of the DCCir Opinion

Substantial Evidence

As to the statutory definition of whistleblower, DCCir ultimately concludes that Dodd Frank provided that a whistleblower could be two or more "individuals acting jointly who provide, information relation to a violation . . ." at Page 10 of the DCCir Opinion. Further, the Court seems unwilling to impose upon the SEC what could be a somewhat arduous process of trying to parse the degree of contribution among joint whistleblowers beyond that it came from a team in the form of a group of people. Notably, the Court admonishes Johnston that [Ed: footnote omitted]:

[A] single attorney, Mr. Blumenfeld, represented both men at their meeting with the Commission staff, and later wrote to the SEC on their behalf recounting that "Michael Johnston and Michael Mittman . . . voluntarily presented to the SEC a portion of the original research and independent analysis developed by the Johnston Team pertaining to the Falcon and [ASTA]/MAT Funds." Indeed, Johnston's own award application says not only "The Johnston Group discovered the . . . results of the MAT backtest," which is irrelevant, but also "the Johnston [G]roup was able to conduct their Independent Analyses and to present them to the SEC in 2010 and 2011." Therefore, we hold the SEC had substantial evidence that Johnston and Mittman acted jointly when providing the information to the Commission.

at Pages 13 - 14 of the DCCir Opinion

So Obtuse As To Be Insulting

Finally, the Court expresses its exasperation with what it views as Johnston's somewhat rigid interpretations [Ed; footnote omitted]:

Johnston next argues that because he and Mittman filed separate award applications, the two cannot be considered joint whistleblowers. As the SEC points out, however, nothing in the statute or its regulations requires the Commission to consider how an individual styles his award application in determining whether he is a joint or solo applicant. 

Finally, in an argument so obtuse as to be insulting, Johnston quotes a portion of the SEC's regulations stating "[a] whistleblower must be an individual," from which he purports to infer a whistleblower cannot be two or more individuals acting jointly. 17 C.F.R. § 240.21F-2(a)(2). In fact, the quoted phrase simply distinguishes an individual from "[a] company or other entity" because those entities are "not eligible to be a whistleblower." Id. Indeed, the immediately preceding portion of the regulation contradicts Johnston's position because it states: "You are a whistleblower for purposes of Section 21F of the Exchange Act (15 U.S.C. 78u-6) as of the time that, alone or jointly with others, you provide the Commission with [qualifying] information." Id. at § 240.21F-2(a)(1).

at Page 12 of the DCCir Opinion

Dismissed and Denied in Parts

In its concluding remarks, DCCir ruled that:

The SEC whistleblower statute does not ask who developed the original information that led to a successful resolution of a covered action; instead, it asks who provided that information to the Commission. The SEC did not err as to the law, nor did it lack substantial evidence as to the facts, in determining that Johnston and Mittman acted as joint whistleblowers when they provided information to the Commission, making Mittman eligible for an award. Johnston's petition for review is therefore

Dismissed in part and denied in part.

at Page 15 of the DCCir Opinion