In the wake of Federal District Judge Jed S. Rakoff's recent rejection of a proposed settlement between the Securities and Exchange Commission and Citigroup Inc., many securities lawyers predicted talks between the securities regulator and financial firms under investigation will come to a screeching halt.

In his Nov. 28 decision, Rakoff denied the SEC's request to approve a $285 million settlement with Citi over the firm's 2007 marketing of the billion-dollar Class V Funding III, a fund the SEC alleged the bank used to dump poorly performing mortgage-backed assets on unsuspecting investors. After assuring investors the securities were an attractive place to put their money, the SEC alleged, Citi then took out short positions against many of the assets in the fund.

Rakoff took aim not only at the Citigroup settlement itself, but criticized the long-standing SEC practice of allowing firms and executives to settle misconduct claims without admitting or denying the underlying accusations. The practice, he said, has been "hallowed by history, but not by reason."

He suggested that too many settlements are like Citi's, where there was "little real doubt" that the firm disagreed with the allegations but would rather settle than run the risk of losing a case that would open the firm to hundreds of millions of dollars of potential liability in civil suits.

This is the third SEC settlement related to the financial crisis that federal judges have questioned since August 2009, when Rakoff initially refused to accept a deal with Bank of America Corp. over its purchase of Merrill Lynch. Similarly, Judge Ellen Segal Huvelle ordered the SEC to strengthen a third settlement, also with Citigroup, in August 2010. 

Rakoff's latest opinion prompted speculation that financial firms will be less willing to enter "neither admit nor deny" settlements because they now have more to lose from settling and may prefer to take their chances at trial. This increased litigation will force the SEC to shift resources from investigations to the courtroom, thus reducing the number of allegations that can be looked into.

But that dire assessment may be exaggerated. In his ruling Rakoff favorably cited a previous settlement in a similar case against Goldman, Sachs & Co. The Goldman settlement offers a road map to the type of agreement he and other judges are likely to accept. For instance, he said the fine levied against Goldman is sufficiently high to discourage future transgressions. The firm paid a $535 million penalty -- more than 35 times the $15 million in gains it had pocketed. Citigroup, by comparison had agreed to pay less than double the $160 million in profits created by its alleged fraud -- "pocket change" as Rakoff called it.

Rakoff also noted that Goldman Sachs agreed to stronger remedial measures than what the SEC proposed for Citi.

Mark Sheppard, partner in the litigation department at Philadelphia's Montgomery, McCracken, Walker & Rhoads LLP, says the SEC may find defendants are less willing to cooperate with the agency but says predictions that this will be the death knell of settlement are overblown. "Right now there's almost a race to get in there and cooperate. The decision may put the brakes on that a little bit," he says. "I would have a harder time going to my clients and saying they have to do this, but it's OK because a deal allows them to fight civil suits."

However, even though settlements may become harder to put together they still will be useful in avoiding costly litigation. "I don't think the sky is falling when it comes to settlements," Sheppard, says. "A careful reading of what Rakoff said reveals there is room to maneuver."

Although the SEC criticized Rakoff's ruling as a violation of the separation of powers, Sheppard predicts neither the agency nor Citi will appeal. "Rakoff is not the only judge who feels this way and is not an outlier," he says. But because settlements have become standard practice, it took someone with the respect Rakoff has earned from his fellow judges to put an end to business as usual.

And even among private attorneys there has been acknowledgement that settlements rarely have the teeth needed to be a true deterrent to future wrong-doing. "Since the early 1970s everybody has chuckled and looked at the way this is set up as sort of a fiction," Sheppard says.

Bill McConnell is The Deal magazine's Washington bureau chief.