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 said that U.S. District Judge Jed Rakoff in Manhattan appeared to have failed to give proper deference to the SEC, and may have overlooked the potential that Citigroup did nothing wrong.

While saying it needed to hear further arguments, the 2nd Circuit said there was a strong likelihood that Rakoff's decision would be overturned.

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

Rakoff rejected the settlement on November 28. He said the SEC's failure to require Citigroup to admit or deny the charges left him no way to know whether the settlement was fair.

That part of the ruling called into question the SEC's decades-long practice of not requiring settling companies to admit or deny its charges.

He also called the $285 million payout pocket change for the third-largest U.S. bank, and said the accord did not serve the public interest.

The SEC and Citigroup had no immediate comment. Rakoff, who is sitting with the 2nd Circuit this week to hear cases, was also not immediately available for comment.

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

(Reporting By Jonathan Stempel in New York; Additional reporting by Grant McCool in New York and Aruna Viswanatha in Washington, D.C.; Editing by Mark Porter and Gerald E. McCormick)