The Wall Street occupiers had been chased out of Zuccotti Park a couple of weeks earlier, but you could hear the echoes of their frustration in a dramatic ruling issued just a few blocks away on Nov. 28, 2011. The opinion, by Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York, rejected a settlement between the Securities and Exchange Commission (SEC) and Citigroup Global Markets. In doing so, Judge Rakoff directly challenged the practice of negotiated settlements—the primary mechanism for resolving corporate regulatory violations.

The proposed settlement, he wrote, was not reasonable, fair, adequate or in the public interest, for the central reason that it leaves the facts of a particularly egregious chain of allegations shrouded in ambiguity.

“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,” Rakoff wrote. “In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

That’s heavy stuff, and probably gratifying to the millions of Americans angry at the lack of perceptible accountability for the financial shenanigans that caused or were revealed by the global financial crisis. But the sweeping language of the opinion does more than reject the Citigroup settlement—it calls into question the process by which companies are penalized without admitting guilt. The pending appeal could have far-reaching ramifications for business and regulators alike.

“This has suddenly taken on real importance,” says Logan Robinson, a professor at the University of Detroit Mercy School of Law, and a former auto industry general counsel. “The 2nd Circuit, in making its decision, will not want to make a huge policy change but, nevertheless, it will have to address whether the SEC has the authority to reach settlements with defendants that do not force them to admit liability. I don’t see how it can run away from that.”

Editor’s note: In a significant policy change, the SEC announced on Jan. 6 that it would no longer allow companies to neither admit nor deny charges in instances where they had been convicted of, or admitted to, the same allegations in criminal proceedings. The change does not apply, however, to situations such as the Citigroup case, in which there are no criminal charges.

Pocket Change

The SEC’s case against Citigroup alleged that in 2007, as the sub-prime lending crisis mounted, the company bundled some of its most dubious assets into a billion-dollar fund and sold them to investors. A parallel filing alleges that Citigroup knew it would be difficult to peddle a product that obviously was a vehicle for unloading bad assets, so it told investors a third-party adviser had compiled the portfolio. To top it off, the company then took a short position against the fund.

“Every case can be complicated, particularly in the [collateralized debt obligation] CDO arena where there has to be somebody betting up and somebody betting down. That’s the only way it works,” says Tom Hatch, a financial litigation partner at Robins, Kaplan, Miller & Ciresi. “But you wouldn’t expect the arranger who is selling it to you to be the one betting against you.”

According to court documents, Citigroup made a $160 million profit. The investors lost $700 million. The proposed settlement with the SEC included disgorging the $160 million, adding $30 million in interest and a $95 million fine.

The total penalty of $295 million, Judge Rakoff wrote, “still leaves the defrauded investors substantially short-changed.” He also noted that $295 million is “pocket change” to an organization of Citigroup’s size.

Whether his opinion ultimately proves a game-changer, however, is now up to the 2nd Circuit.

Clear as Mud

The proposed settlement is not at all out of line with the formula the SEC generally uses in such cases: disgorged profits, plus interest, plus a fine based on the probability of prevailing in court. The government gets to state the allegations and allocate some restitution, and the company avoids the secondary litigation and insurance issues that would inevitably follow an admission of guilt.

That approach rings hollow to a public that expects accountability.

“A case like this elevates the public policy aspect of what the SEC does, front and center,” says Chris Robertson, co-chair of the securities litigation group at Seyfarth Shaw and a former SEC staff lawyer. “It puts new scrutiny on how settlements are structured and approved.”

That scrutiny has the potential to make a lot of people uncomfortable. Except in class actions, companies aren’t used to explaining how they arrive at settlements. Regulators historically have enjoyed deference from the courts in the expectation that they are properly exercising their authority and responsibility to the public good. Greater transparency in the settlement makes both sides nervous.

Risk Aversion

As a practical matter, while regulatory actions are built almost entirely around the threat of litigation, going to court is the last thing either side wants. A regulator such as the SEC does not have the resources for even a handful of major cases, nor does it have the talent to match the top-shelf defense lawyers that major financial institutions would inevitably bring to bear in what would be de facto, bet-the-company cases.

“There’s a lot of risk aversion on both sides in these cases—it’s not just the defendants who are worried about losing,” Robinson says. “When the government makes a big deal of going after a company and loses, it’s humiliating—it destroys careers. My personal view is the 2nd Circuit will have to repair this and permit the SEC to return to the neither-admits-nor-denies standard. I don’t think they can really operate without it.”

If that occurred, it would be something of a backfire for Judge Rakoff, potentially resulting in less judicial ability to countermand the SEC when presented with settlement consent orders. Not everyone thinks the 2nd Circuit will be so one-sided, however.

“My sense is even if they overturned his decision, they would remand it and direct the SEC to provide more information,” Robertson says. “Handicapping it, they may pull back a little bit on what [Judge Rakoff has] done, but at the same time make a pretty clear statement to the government that if they’re going to come into a court with a settlement, they need to embed it with more detail about how they got there and their rationale. Ultimately, that’s probably the right result.”