A federal judge angrily blocked Citigroup Inc's proposed $285 million settlement over the sale of toxic mortgage debt, excoriating the top U.S. market regulator over how it reaches corporate fraud settlements.

U.S. District Judge Jed Rakoff in Manhattan said the U.S. Securities and Exchange Commission appeared uninterested in actually learning what Citigroup did wrong, and erred by asking him to ignore the interests of the public.

An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous, Rakoff wrote in an opinion dated on Monday.

The judge added that it was difficult to discern from the limited information before the court what the SEC is getting from this settlement other than a quick headline.

He said the proposed settlement was neither reasonable, nor fair, nor adequate, nor in the public interest.

Danielle Romero-Apsilos, a Citigroup spokeswoman, declined immediate comment, as did the SEC.

In its complaint, the SEC accused Citigroup of selling a $1 billion mortgage-linked collateralized debt obligation, Class V Funding III, in 2007 as the housing market was beginning to collapse, and then betting against the transaction.

One Citigroup employee, director Brian Stoker, was also charged by the SEC. He is contesting those charges. Rakoff consolidated the two cases, and set a July 16, 2012 trial date.

Rakoff has been a thorn in the side of the SEC, having in 2009 rejected its initial proposed settlement with Bank of America Corp over its takeover of Merrill Lynch & Co.

Monday's decision throws into question the SEC's policies toward settlements with publicly traded companies, at a time when the regulator is trying to burnish its reputation for tough enforcement amid skeptics from Congress and elsewhere.

NO ADMISSION OF WRONGDOING

Rakoff called the Citigroup accord too lenient, noting that the bank was charged only with negligence, neither admitted nor denied wrongdoing, and could avoid reimbursing investors for more than $700 million of losses. Private investors cannot bring securities claims based on negligence.

If the allegations of the complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business, the judge wrote.

The settlement would have required the third-largest U.S. bank to give up $160 million of alleged ill-gotten profit, plus $30 million of interest. It also would have imposed a $95 million fine for the bank's alleged negligence, less than one-fifth what Goldman Sachs Group Inc paid last year in a $550 million SEC settlement over a different CDO.

Rakoff called the $95 million fine pocket change for Citigroup, and said investors were being short-changed.

The SEC 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, he wrote.

In 2009, Rakoff had struck down the SEC's $33 million settlement with Bank of America over Merrill, saying it punished shareholders who were victims of the alleged fraud. He later approved a $150 million accord.

Citigroup shares were trading up 6.6 percent at $25.18 on Monday afternoon in a rising market amid optimism that a solution to Europe's debt crisis might be found.

The case is SEC v Citigroup Global Markets Inc, U.S. District Court, Southern District of New York, No. 11-07387.

(Editing by Derek Caney and Matthew Lewis, editing by Gerald E. McCormick)