NEW YORK, Nov 28 (Reuters) - A federal judge angrily threw out 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 that in agreeing to the settlement, the Securities and Exchange Commission appeared uninterested in actually learning what Citigroup did wrong. He also said the regulator 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 Monday.

"In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth," he added.

Rakoff called the settlement "neither reasonable, nor fair, nor adequate, nor in the public interest," and said it was hard to tell whether by settling the SEC was getting more than "a quick headline." He set a trial date of July 16, 2012.

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 in Congress and elsewhere.

Many SEC cases against Wall Street banks and investment firms are settled out of court, without any admission or denial of wrongdoing. The absence of agreed-upon facts can make it harder for shareholders, bondholders and others to bring their own civil lawsuits against those same defendants.

THORN

Both the SEC and Citigroup on Monday maintained that the settlement was reasonable.

Robert Khuzami, the SEC director of enforcement, said the $285 million sum "reasonably reflects the scope of relief that would be obtained after a successful trial," but without the "risks, delay and resources" required.

He also said Rakoff ignored "decades of established practice throughout federal agencies and decisions of the federal courts."

Citigroup spokeswoman Danielle Romero-Apsilos called the settlement "a fair and reasonable resolution to the SEC's allegation of negligence." She said if a trial occurred, the bank would present "substantial factual and legal defenses."

The SEC and Citigroup did not in their statements address whether they might be able to reach a revised settlement that could win court approval.

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.

The SEC said the CDO caused more than $700 million of investor losses. One Citigroup employee, director Brian Stoker, was charged by the SEC, and is contesting those charges.

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

Bradley Bondi, a partner at Cadwalader, Wickersham & Taft and former counsel to two SEC commissioners, said the decision will hamper the regulator's ability to settle cases in the Manhattan court.

"But the judge's decision to probe the settlement to ensure it is in the best interest of shareholders - and requiring the SEC to show the facts in support ... are in the best interests of process," Bondi said in an email.

'POCKET CHANGE'

Rakoff called the Citigroup accord too lenient, and noted that the bank was charged only with negligence. 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 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."

Khuzami said the regulator will review the ruling and "take those steps that best serve the interests of investors."

In striking down the SEC's $33 million settlement with Bank of America over Merrill, Rakoff said it unfairly punished shareholders. He later approved a $150 million accord.

Citigroup shares closed 6 percent higher at $25.05 on Monday. Stocks rose broadly on optimism that leaders in Europe might take steps to address the region's debt crisis.

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

For the SEC: Matthew Martens, Jeffrey Infelise, Kenneth Lench, Reid Muoio and Thomas Silverstein of the SEC.

For Citigroup: Brad Karp, Susanna Buergel and Theodore Von Wells Jr. of Paul, Weiss, Rifkind, Wharton & Garrison.

(Reporting by Grant McCool and Jonathan Stempel)

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