When the Securities and Exchange Commission struck a deal with Citigroup over a failed security that the bank sold to investors, we asked whether regulators had handed Citigroup too sweet a deal.

Today in Manhattan, U.S. District Judge Jed Rakoff appeared to reach that very conclusion: “If the allegations of the Complaint are true, this is a very good deal for Citigroup,” Rakoff wrote as he refused to sign off on the $285 million proposed settlement agreement.

While the full opinion is worth reading, here’s a summary of the judge’s objections:

The SEC's allegations don’t match the charges.

The SEC, in its complaint, alleged that Citigroup knowingly misrepresented or failed to disclose to investors key information about the collateralized debt obligation, or CDO, known as Class V Funding III. We first reported on Class V last year in our story on CDO self-dealing, noting that the CDO contained risky pieces of other Citigroup CDOs.

Specifically, the SEC charged that Citi put risky assets into the deal, bet against it and didn’t disclose that to investors. According to the SEC, “Citigroup knew it would be difficult” to sell the CDOs if it disclosed all that to investors.

Judge Rakoff concluded, “This would appear to be tantamount to an allegation of knowing and fraudulent intent.”

But in the end, the SEC only charged Citigroup — and one low-level exec — with negligence, for which there's a lower standard of proof than for intentional fraud. Charges were not filed against more senior Citi execs who, according to the SEC, also knew details of the deal.

The settlement's boilerplate language forbidding future violations by Citigroup is essentially meaningless.

“By the S.E.C.’s own account, Citigroup is a recidivist,” wrote Rakoff, who noted that the SEC had not sought to enforce that prohibition for at least a decade.

The context here is more than adequately explained by a recent New York Times article that found that Citigroup had agreed on at least four other occasions not to violate that same anti-fraud statute, only to continually break that promise.

The fine is too modest to have a deterrent effect.

According to Rakoff, the fine in this case is “pocket change to any entity as large as Citigroup” and amounts to just a cost of doing business.

Rakoff loathes the longstanding practice of reaching settlements without admissions of wrongdoing.

Sure, it’s standard in deals like this, and judges have routinely signed off on such language, but Rakoff has signaled that he has serious qualms about non-admission, non-denial settlements.

For one, he said the Citi deal shortchanges investors, who lost more than $700 million, according to the SEC: With no mea culpa from Citi, private investors will have a much harder time bringing their own lawsuits against the company — which, for Citigroup, is precisely the point.

Rakoff also argued that this practice cheapens judicial power, which must be used in conjunction with “cold, hard, solid facts.” A non-admission of guilt but agreement to pay, while in keeping with conventional procedure, denies the court of established facts on which to decide whether the settlement is reasonable, he said.

The truth should come out.

Finally, Rakoff argued that, especially regarding the financial sector – and especially now, the public deserves to know the truth: “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.”

One thing Rakoff didn’t touch on? A discrepancy we raised last month: Citigroup seems to believe this deal would have settled all of its potential liability over CDOs — something the SEC has denied.

The SEC’s response

The SEC issued a statement today defending its settlement: “We believe that the proposed $285 million settlement was fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial,” said RobertKhuzami, the SEC’s head of enforcement.

Khuzami pointed out that Rakoff’s objection to the lack of an admission of guilt “ignores decades of established practice throughout federal agencies and decisions of the federal courts.”

That response is in line with what Khuzami has said in the past — that securing confessions from companies like Citi, while ideal, would slow down the agency’s investigations.

“No one disagrees with the sort of abstract notion that you’d like to have admissions in your cases,” Khuzami said earlier this month. “One has to make choices between competing demands.”

The SEC also has argued that taking banks to costly trials would divert scarce resources from its other efforts to fight securities fraud, and prove counterproductive.

What’s next?

The case has been scheduled for trial next year — something Citigroup would presumably like to avoid, given the mountains of evidence in the SEC’s possession that would become public in a trial.

But a trial is still not a sure thing. Rakoff initially rejected a proposed SEC settlement with Bank of America but eventually approved a deal last year after the agency came back with a bigger fine. It remains to be seen whether the SEC will try to do the same this time around.