"In short, we conclude it is doubtful whether the court gave the obligatory deference to the SEC's views in deciding that the settlement was not in the public interest," said a three-judge panel for the U.S. Court of Appeals for the 2nd Circuit. It also suggested Rakoff misinterpreted past precedent on the way "public interest" should be evaluated.

The ruling deals at least a temporary blow to the maverick judge's drive to force the SEC to revamp how it crafts settlements in misconduct cases where the charged party does not admit guilt. Rakoff has criticized the practice, saying that the SEC doesn't adequately explain how the settlements are in the public interest. In a sign the appeals court believes Rakoff's concerns have some merit, it also took the rare step of ordering the appointment of an independent counsel to represent Rakoff's viewpoint when the appeals court holds a full hearing on the SEC and Citigroup's appeal of the Rakoff ruling.

"It is extremely unusual to ask for a counsel to be appointed to argue the district court's view of the case," said Mark B. Sheppard, a partner in Montgomery McCracken Walker & Rhoads LLP's securities practice. "The court was trying to be deferential to Judge Rakoff."

In his controversial decision late last year, Rakoff tossed out an agreement settling charges that Citigroup illegally marketed collateralized debt obligations to investors while at the same time it was internally discounting their worth and in some cases betting against their value.

Calling the settlement amount "pocket change," Rakoff said the SEC hadn't done enough to protect consumers because Citigroup failed to admit any liability. He ordered the parties to come up with a new deal. The SEC and Citigroup both appealed the rejection.

The appeals panel, while granting the stay and questioning the judge's reasoning, also said the case raises novel questions that should be heard and indicated that was why it was ordering the appointment of an independent counsel to argue Rakoff's viewpoint.

"The challenge raises important questions, the judges said. "These include the division of responsibilities as between the executive and the judicial branches and the deference a federal court must give to policy decisions of an executive administrative agency as to whether its actions serve the public interest (and as to the agency's expenditure of its resources).

"They include also the question of a court's authority to reject a private party's decision to compromise its case on the ground that the court is not persuaded that the party has incurred any liability by its conduct."

The panel said it granted the stay because legal arguments suggested the judge overstepped his bounds.

Rakoff in his original opinion said the SEC's consent agreement didn't serve the public interest for three reasons.

He said a settlement without some admission of Citigroup guilt, while potentially in the parties' interest, offered little more than "a quick headline" and left defrauded investors looking to pursue individual claims "substantially short-changed." He said a settlement could be unfair to Citigroup because it imposes substantial obligations "on the basis of mere allegations." Finally, Rakoff questioned how he could know a settlement was "adequate" without knowing more facts.

"An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous," Rakoff wrote. "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. 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."

The appellate panel questioned all three arguments. It suggested judges needed to defer to executive agencies on whether a settlement is "in the public interest." It suggested Rakoff's argument unfairly assumed Citigroup's guilt, rather than that it chose to settle arguments that might not be provable. Finally, it suggested that judges could make decisions based on available information.

Both the SEC and Citigroup praised the ruling.

"We are pleased that the appeals court found 'no reason to doubt' the SEC's view that the settlement is in the public interest," said Robert Khuzami, director of the SEC's Division of Enforcement. "As we have said consistently, 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. Equally important, this settlement approach preserves resources that we can use to stop other frauds and protect other victims."

Citigroup said only that it was "pleased" with the ruling.

Meanwhile, Dennis Kelleher, president-CEO of Better Markets Inc., said he was hopeful the court in the full hearing would address some of the issues about settlement Rakoff's ruling raised.

"We continue to believe Judge Rakoff got it right in rejecting this settlement and are confident that the circuit court, when it hears the case on the merits, will conclude that the SEC and settling parties must present significantly more information to evaluate a proposed settlement," he said. "That is the only way a court can do its job and not just be a rubber stamp."