He had a point. Source: The Washington Post via Getty Images
He had a point. Source: The Washington Post via Getty Images

The U.S. Court of Appeals, in resolving a dispute between a federal judge and the Securities and Exchange Commission, has raised an important question: Should judges be allowed to second-guess the deals that the SEC strikes with alleged lawbreakers?

The court asserted that the law says no. In that case, the SEC should hold itself to a higher standard.

At issue is Judge Jed Rakoff's refusal of a settlement the SEC reached with Citigroup Inc. in 2011. The agency had accused the bank of misleading investors in a $1 billion mortgage investment by concealing that the bank's own traders had designed the investment to fail and were betting against it. Under the deal, the bank would pay a $285 million fine without admitting or denying guilt, and promise not to break the law in the future.

Rakoff argued that unless he knew which of the SEC's allegations were true, he couldn't assess whether the settlement was adequate, fair or reasonable. He noted that in a similar case involving Goldman Sachs Group Inc., the SEC had extracted a much larger penalty and required the bank to admit to certain facts. With no admission, perpetrators can keep denying what actually happened, and victims are deprived of evidence they can use in their efforts to recoup losses -- which, in the Citigroup case, the SEC estimated at more than $700 million.

The appeals court ruled that Rakoff interpreted his remit too broadly -- that the judge's role in approving settlements should be limited more or less to making sure the parties have their papers in order and understand what they're doing. Such deals, it said, are for managing risks, not necessarily establishing truth. That the SEC is "politically liable" to the people, the court reasoned, should be enough to ensure it acts in their best interests.

Recent experience strongly suggests that political liability alone isn't enough. The SEC also faces other pressures, such as large financial institutions' immense lobbying power and a heavy workload. Far too often, the agency has allowed companies to settle charges without admitting or denying guilt, then failed to hold them to their promises to obey the law. When the SEC cut its deal with Citigroup, for example, it already had two cease-and-desist orders in place barring the same unit of the bank from violating the same sections of the securities laws.

In short, even if Rakoff exceeded his authority, he was right about the SEC's approach. If the agency believes it has enough evidence to press charges and impose punishment, it should get the defendant to confirm the facts, if not admit to breaking the law. If its actions are restricted to fines and unenforced promises, who can know whether it is letting the guilty off easy or shaking down the innocent?

Rakoff's activism, and that of other judges who have also questioned SEC settlements, appears to have had some effect: Since 2012, the agency has been moving toward requiring more admissions from companies. It's not too late to require the same in the Citigroup settlement. The appeals court decision is a perfect opportunity for the SEC to show that it can, even without being compelled by a judge, do the right thing.

To contact the senior editor responsible for Bloomberg View's editorials: David Shipley at davidshipley@bloomberg.net.