NEW YORK (Reuters)—A federal appeals court stopped just short of throwing out a judge's controversial rejection of the U.S. Securities and Exchange Commission's $285 million settlement with Citigroup Inc. in a fraud case.

The 2nd U.S. Circuit Court of Appeals chastised U.S. District Judge Jed Rakoff in Manhattan, saying there was "no reason to doubt" the SEC's determination that the Oct. 19 settlement was in the public interest.

Judge Rakoff threw out the settlement on Nov. 28, saying the failure to require Citigroup to admit or deny the SEC charges left him no way to know whether the settlement was fair.

His opinion threatened to undermine the SEC's decades-long practice in reaching settlements.

While saying it needed further arguments, the 2nd Circuit said there is a "strong" likelihood it would overturn Judge Rakoff's decision, clearing the way for a settlement. It put lower court proceedings on hold, throwing a scheduled July trial in doubt.

The settlement was intended to resolve civil charges that Citigroup sold $1 billion of risky mortgage-linked securities in 2007 without telling investors that it was betting against the debt, and causing investors more than $700 million of losses.

In its decision, a three-judge panel of the appeals court faulted Judge Rakoff for appearing to have overlooked the potential that Citigroup did nothing wrong, and would never have settled had it been required to admit liability.

Judge Rakoff "believed it was a bad policy, which disserved the public interest, for the SEC to allow Citigroup to settle" without addressing the issue of liability, the 2nd Circuit panel said. "It is not, however, the proper function of federal courts to dictate policy to executive administrative agencies."

The panel also said requiring an admission of liability might even hurt the public interest, because it "would in most cases undermine any chance for compromise."

Judge Rakoff has long been a thorn to the SEC, and has tried to ensure that settling companies are punished sufficiently for activity that harms investors, and also that they mend their ways.

In 2009, he rejected a proposed $33 million settlement between the agency and Bank of America Corp. over the takeover of Merrill Lynch. He later half-heartedly approved a reworked accord.

Thursday's decision "begs the question of whether these judges paid any attention to the role both institutions played in the recent financial crisis," said Frank Partnoy, a professor at the University of San Diego School of Law. "It is a major setback for anyone who thought the courts might stand up for the rights of investors when the SEC does not."

Because the SEC and Citigroup are on the same side, the appeals court asked a courthouse clerk to appoint someone to argue on appeal for upholding Rakoff's reasoning.

"The 2nd Circuit has laid a tough path for whomever is appointed," said Jayne Barnard, a professor at William & Mary Law School. "It will be an interesting exercise but the court seems unimpressed by Judge Rakoff's reasoning so far."

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Judge Rakoff is sitting with the 2nd Circuit this week to hear other cases. He was not immediately available for comment.

In afternoon trading, Citigroup shares were up 3.3 percent, at $36.37 on the New York Stock Exchange.

Citigroup and the SEC said they were pleased with Thursday's decision.

"We agree to settlements when the terms reflect what we reasonably believe we could obtain if we prevailed at trial, without the risk of delay and uncertainty that comes with litigation," said Robert Khuzami, the SEC's enforcement chief. "Equally important, this settlement approach preserves resources that we can use to stop other frauds and protect other victims."

In his biting November opinion, Judge Rakoff said that approving a settlement without knowing the underlying facts was wrong. "An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous," he wrote.

The judge also called the $285 million payout, including restitution and a $95 million fine, "pocket change" for the third-largest U.S. bank, and that by settling the SEC appeared more interested in a "quick headline."

Lynn Stout, a professor at Cornell Law School, called the 2nd Circuit's response "somewhat shocking."

"The 2nd Circuit appears to be giving the SEC carte blanche in deciding what is in the public interest in settling cases against financial institutions," she said. "This is especially troubling as the SEC is a party itself to the settlement."

Other major banks including Goldman Sachs Group Inc., JPMorgan Chase & Co. in the last two years also reached large settlements with the SEC without admitting wrongdoing.

One Citigroup employee, Brian Stoker, was also charged by the SEC in the case, and has contested those charges. He was not a party in Thursday's appeal.

Thursday's panel included Circuit Judges John Walker, Pierre Leval and Rosemary Pooler. Judge Walker was appointed to the bench by President George H.W. Bush, and Judges Leval and Pooler by President Bill Clinton. Judge Rakoff was also appointed to the bench by President Clinton.

The case is SEC vs. Citigroup Global Markets Inc., 2nd U.S. Circuit Court of Appeals, No. 11-5227.