Court Hears Arguments on Judge’s Rejection of S.E.C.-Citigroup Deal

4:56 p.m. | Updated

Judge Jed S. Rakoff has been an outspoken critic of the Securities and Exchange Commission, chiding the agency’s practice of allowing companies to settle fraud cases without having to admit that they had done anything wrong.

On Friday, it was the S.E.C.’s turn to criticize him.

In an unusual hearing before the federal appeals court in Manhattan, lawyers for the S.E.C. — along with lawyers for Citigroup — tried to convince a three-judge panel that Judge Rakoff, a trial court judge, exceeded his authority in rejecting the settlement that let Citigroup avoid an admission of wrongdoing.

“The court failed to give the S.E.C. any deference in this case,” said Michael A. Conley, the commission’s deputy general counsel.

Judge Rakoff, who was represented by a court-appointed lawyer, did not attend the argument, which took place before a packed courtroom at the United States Court of Appeals for the Second Circuit in Manhattan.

A judge does not have to “automatically approve whatever consent decree the S.E.C. brings him and assume that it is in the public’s interest,” said John R. Wing, the lawyer for Judge Rakoff.

The judges did not indicate how they would rule, but the argument came almost a year after a different appeals court panel, in a mostly procedural decision, indicated that it believed that Judge Rakoff had overstepped the bounds.

The decision by the Second Circuit, an influential appellate court, could have broad legal ramifications. Other government bodies like the Federal Trade Commission and the Justice Department’s antitrust division also routinely use the “neither admit nor deny wrongdoing” language in settling enforcement cases with corporate defendants.

A ruling in Judge Rakoff’s favor could embolden the judiciary to refuse to approve such settlements. That, according to the government, would overburden federal agencies that are already resource-constrained. If the S.E.C. and others were required to extract an admission of wrongdoing from a corporation, there would most likely be fewer settlements and more trials, which are costly.

Brad S. Karp, a lawyer for Citigroup, highlighted this concern, emphasizing the potential repercussions of judges’ overriding government agencies and forcing them to require defendants to acknowledge wrongdoing.

“Many corporations will decide to not settle matters if a requirement is to admit liability,” Mr. Karp said. “The federal regulatory enforcement regime would screech to a grinding halt.”

In court papers, Judge Rakoff’s lawyers dismissed such a claim as “needlessly alarmist.”

The S.E.C.’s civil fraud action against Citigroup related to the sale of a complex $1 billion mortgage bond deal during the waning days of the housing boom. Citigroup was accused of deceiving its customers by selling them pools of risky mortgages that the bank knew would decline in value. Clients suffered more than $600 million in losses.

Citigroup agreed to play $285 million to settle the complaint, but Judge Rakoff rejected the settlement. He derided the amount of money that Citigroup had agreed to pay, calling it “pocket change” for the bank. And in settling the case without proving that Citigroup committed fraud, the parties deprived the public “of ever knowing the truth in a matter of obvious public importance,” Judge Rakoff wrote.

He ordered the parties to prepare for trial, but that was postponed after the commission and Citigroup appealed Judge Rakoff’s rejection of their deal.

Historically, judges have rubber-stamped S.E.C. settlements with banks and other defendants accused of civil fraud. Such settlements require court approval, and the judge is charged with finding that the settlement is “fair, reasonable, adequate and in the public interest.”

But Judge Rakoff, who in his two decades on the bench has earned a reputation as iconoclastic, bucked that longstanding practice. In 2009, he scuttled what he viewed as a sweetheart settlement between the commission and Bank of America related to the bank’s troubled acquisition of Merrill Lynch. And in 2011, he rejected the S.E.C.-Citigroup deal.

The rulings became a cause célèbre in the wake of the financial crisis, a time when the commission and other federal authorities were being criticized for failing to hold large banks accountable.

Following Judge Rakoff’s lead, federal judges in Brooklyn, Colorado and Wisconsin have demanded greater accountability, or more information, from defendants before signing off on settlements struck with the S.E.C. and other government agencies. Judge Richard J. Leon, a federal judge in the District of Columbia, recently refused to approve a settlement between the S.E.C. and I.B.M. without more data about the allegations.

But on Friday, the S.E.C. argued that Judge Rakoff’s ruling conflicted with a century of judicial practice. Courts have given substantial deference to federal agencies’ decisions to settle cases, approving thousands of previous settlements, the commission said in its court papers. Citigroup agreed, writing in its brief that especially when a federal agency is involved, “the scope of a court’s authority to second-guess an agency’s discretionary and policy-based decision to settle is at best minimal.”

Underscoring the importance of the case for the S.E.C., Robert S. Khuzami, whose last day as the commission’s director of enforcement was Friday, and George S. Canellos, his acting successor, attended the hearing.

Mr. Wing told the three-judge panel — Rosemary S. Pooler, Raymond J. Lohier Jr. and Susan L. Carney — that the S.E.C. and Citigroup had mischaracterized the judge’s ruling. All Judge Rakoff wanted, Mr. Wing said, was additional evidence from the two parties so he could exercise his judgment.

“The S.E.C.’s and Citigroup’s concept of deference — in which courts would be effectively reduced to potted plants — would surely undermine the independence of the federal judiciary,” Judge Rakoff’s lawyers wrote in their court papers.

Judge Lohier alluded to this concern, and added some levity to the proceedings, when he posed a hypothetical to Mr. Conley, the lawyer for S.E.C. What if, he asked, the agency had settled with Citigroup for only $100,000? Would a judge then have the authority to reject that deal?

“It’s very unlikely that the S.E.C. would ever settle with Citigroup for that amount,” Mr. Conley replied.

Judge Lohier cut Mr. Conley off. “That’s why it’s called a hypothetical,” he said.