The Securities and Exchange Commission is certain to appeal Monday’s 15-page decision by Manhattan federal district court judge Jed Rakoff refusing to approve the agency’s $285 million settlement with Citigroup. And it’s nearly impossible to envision the U.S. Court of Appeals for the Second Circuit upholding the ruling, since, as Judge Rakoff himself noted, it rejects “the SEC’s long-standing policy–hallowed by history” of allowing defendants to settle without admitting or denying the underlying allegations.

But whether or not it survives, the ruling has already achieved at least two things: Combined with Judge Rakoff’s prior objections to SEC settlements, it reminded the SEC and its Wall Street targets that gaining judicial approval for their behind-the-scenes dealmaking isn’t just a formality, at least in the Southern District of New York. And it cements Judge Rakoff’s reputation for challenging the SEC, even if it means departing with his colleagues on the bench.

As the New York Law Journal reports, Judge Rakoff found that the SEC failed to provide “any proven or admitted facts upon which to exercise even a modest degree of independent judgment” about whether to approve the deal, which would resolve allegations that Citi duped investors by secretly including a large percentage of toxic assets in a $1 billion collateralized debt obligation and then betting against the CDO. He consolidated the case with the SEC’s related fraud suit against Citi employee Brian Stoker and set a July 2012 trial date.

Judge Rakoff has been publicly stewing over the SEC’s approach to settlements with alleged Wall Street malefactors since 2009, when he refused for months to sign off on the SEC’s settlement with Bank of America over alleged disclosure shortcomings its Merrill Lynch acquisition. He ultimately approved that deal early last year after the parties agreed to beef up BofA’s penalty from $33 million to $150 million and to include safeguards against similar conduct in the future. Judge Rakoff was also highly critical of a settlement of backdating claims that the SEC reached with Vitesse Semiconductor earlier this year, though he approved the deal in March.

So what caused the judge to finally boil over in the Citi case and reject the deal altogether? For one, the $285 million settlement combined elements of both the BofA and Vitesse deals that earned his ire. As in the previous cases, Judge Rakoff blasted the SEC for allowing Citigroup to keep mum on its culpability and neither contest not admit to the allegations while nevertheless agreeing to pay a fine. “The injunctive power of the judiciary is not a free roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated,” he wrote. “If its deployment does not rest on facts–cold, hard, solid facts, established either by admissions or by trials–it serves no lawful or moral purpose and is simply an engine of oppression.”

It particularly irked Judge Rakoff that in its separate complaint against Stoker, the SEC claimed that Citigroup knowingly misled investors over the CDO, but its complaint against Citi alleged only that the bank was guilty of negligence. He noted that Citi was “a recidivist” and that the SEC’s financial penalty amounted to “pocket change” for the bank, concluding that the settlement didn’t meet standards he set forth in considering the BofA settlement: that such deals must be fair, reasonable, adequate, and in the public interest.

Judge Rakoff emphatically rejected the SEC’s contention that the pubic interest shouldn’t be part of the standard of review. “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,” he wrote. “[T]he combination of charging Citigroup only with negligence and then permitting Citigroup to settle without either admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation.”

Citi counsel Brad Karp of Paul, Weiss, Rifkind, Wharton & Garrison declined to comment on the decision. SEC enforcement chief Robert Khuzami released a lengthy statement on the ruling, stating that it “ignores decades of established practice throughout federal agencies and decisions of the federal courts” approving similar settlements. “The settlement provisions cited by the court have been included in settlements repeatedly approved for good reason by federal courts across the country–including district courts in New York in cases involving similar misconduct,” Khuzami said.

In June, Manhattan federal district court judge Richard Berman approved the SEC’s $153.6 million settlement with J.P. Morgan Securities in a case that contained closely similar provisions and also dealt with an ill-fated CDO. And in July 2010 Judge Barbara Jones approved the SEC’s $550 million deal with Goldman Sachs over its ABACUS CDO.
Former Skadden, Arps, Slate Meagher & Flom partner Dennis Kelleher, whose public interest group Better Markets sought to intervene in the Citi case to appose the SEC settlement, said in a statement that Judge Rakoff’s ruling means “that the cozy business-as-usual relationship between the SEC and Wall Street might finally be over.” That sounds a bit premature, but we’re sure of one thing: If the case winds up before the Second Circuit, the appeal is going to be one to remember.