A federal judge in New York shot down the controversial settlement between Bank of America and the Securities and Exchange Commission over bonuses paid to Merrill Lynch employees last year.

U.S. District Court Judge Jed S. Rakoff found that the settlement reached on August 3, under which BofA would pay the SEC a $33 million fine, was unfair to BofA’s shareholders. “This proposal to have the victims of the violation pay an additional penalty for their own victimization was enough to give the court pause,” he wrote.

The judge’s ruling marks another setback for the SEC, which has recently come under fire by its own Inspector-General as well as Congress for failing detect the multi-billion Ponzi scheme of disgraced financier Bernard Madoff, despite numerous red flags over several years.

As for the bonus settlement, Rakoff called the proposed agreement “neither fair, nor, reasonable, nor adequate,” while acknowledging that the court usually defers to settlements reached by parties.

Rakoff, who sits in the Southern District of New York, also said the settlement suggested a “cynical relationship” between the SEC and BofA. “The SEC gets to claim that it is exposing wrongdoing on the part of Bank of America in a high-profile merger; the Bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all of this is done at the expense, not only of the shareholders, but also of the truth.”

Judge Rakoff then noted that BofA had stated that if he disapproved the settlement it would litigate the charges, a process Rakoff says may allow the truth to emerge. He directed both parties to file with the court a proposed case management plan within one week that would have the trial scheduled to being on February 1, 2010.

In its complaint against BofA, the SEC alleged that the bank had materially lied to its shareholders in the November 3 proxy statement that requested their approval of its $50 billion acquisition of Merrill Lynch. The SEC claimed that BofA “represented that Merrill had agreed not to pay year-end performance bonuses or other discretionary incentive compensation to its executives prior to the closing of the merger without Bank of America’s consent (when in fact),… Bank of America had agreed that Merrill could pay up to $5.8 billion—nearly 12% of the total consideration to be exchanged in the merger—in discretionary year-end and other bonuses to Merrill executives for 2008.”