FORTUNE -- Until the Securities and Exchange Commission gets its act together, the public might very well be better off with no top financial regulator at all. A friend and fellow parent provided the perfect metaphor for why: Having an ineffective regulator that the public counts on for protection is like being at a swimming pool where little kids wear water wings, parents bury their noses in trashy novels, and the lifeguards are too busy flirting to do their jobs. It sounds great to relax while Jimmy flails away, but having a false sense of security in swimming pools and financial markets can only lead to disaster.
It's important to note that the SEC says it is taking serious steps to improve itself, and thus is owed the benefit of the doubt. And its recent investigations, mostly notably into Goldman Sachs (GS, Fortune 500) but also ICP Capital, bode well for a return to seriousness of purpose. Still, I believe the question we should be asking now is not how to develop effective regulation, but whether the SEC, as it now exists is capable of carrying out effective regulation and never again faltering the way it did in the 1990s and 2000s.
Record of failure
Like the hometown Washington Nationals, the SEC's recent record has been abysmal. There is of course the saga of Bernie Madoff, the commission's defining failure. Though the story of Alan Stanford is also well known, the SEC's role in allowing this $8 billion fraud (alleged) to continue unabated for a decade bears a quick recap:
In mid February 2009, the SEC charged Allen Stanford and other Stanford Financial Group executives with operating a multi-billion dollar fraud. Linda Chatman Thomsen, director of the regulator's Division of Enforcement, said in a statement at the time, "we are moving quickly and decisively in this enforcement action to stop this fraudulent conduct and preserve assets for investors."
"Quickly and decisively," is, however, not how SEC headquarters moved on the Stanford investigation. The SEC's March 31, 2010 Inspector General report asserts that the Fort Worth SEC examination unit repeatedly sought to have Stanford investigated by the Enforcement division, only to be rebuffed. From 1997 to 2005, in fact, Stanford's scheme grew exponentially while the SEC dithered, despite evidence from its own staff and outside whistleblowers showing that Stanford had to be a fraud.
Institutional or individual failure?
One might be tempted to lay the blame at the feet of one rogue SEC agent, namely Spencer Barasch, who the Inspector General's report singled out for quashing multiple attempts to dig into Stanford, and subsequently sought, several times and with increasing chutzpah, to represent Stanford as a lawyer in private practice.
According to the report, when asked why he persisted in his efforts to represent Stanford, Barasch responded, "Every lawyer in Texas and beyond is going to get rich over this case. Okay? And I hated being on the sidelines."
As odious as this statement is, it might not be as bad as Barasch's other reason for failing to investigate: Based on testimony from a coworker, Barasch opted to believe Stanford's attorney, Wayne Secore (himself a former SEC lawyer) who told him there was no case against his client.
The report added that SEC enforcement staff also blamed their inaction on the theory that the Stanford fraud was too complex, and that it would drain resources from simpler cases that boosted the office's "stats," with regional enforcement officials indicating that they were judged by the number of cases they brought.
And in case you thought it was just Barasch, the report additionally mentioned that even after the Enforcement staff did open a "Matter Under Inquiry" into the Stanford case in May 1998, they stopped it after "Stanford refused to voluntarily produce numerous documents."
The problem was also not limited to the affairs of Stanford and Madoff. SEC inspector general David Kotz found "multiple instances of mishandling and mismanagement" in another situation, this one involving Metromedia International Group Inc. "'It looked real complicated, like it would require some work,' one unnamed SEC staff member ... told Kotz," apparently in defense of not pursuing an investigation.
Then, in 2006, "about a year after he was given the assignment, a colleague asked the staff person about his progress and he responded, 'I don't think there is anything you can do. I just haven't been focusing on [the Metromedia International complaints] for a while.' ... 'It's been a long while, but I could have sworn the Metromedia matter was closed,' another SEC staff person wrote in an email, saying 'no action' was required on the filings of Kevin McLaughlin, who tried to alert the SEC to Metromedia's problems .
So which is it? Barasch is a rogue, single-handedly stopping diligent SEC personnel from fulfilling their mandate? Or, Barasch is a rogue, but other SEC personnel didn't exactly fight to make this case, or any others? If you believe the former, then fixing the SEC should be simple enough. But if the latter rings true, and based on SEC representatives' own words, it sure seems to, then the problem is far more systemic, and far more troublesome.
In the words of Miami attorney Bowman Brown, who represents numerous "burned Stanford investors," the [IG] report "has got to send a strong message to Congress that these kinds of [frauds] have far greater impact on just those who were direct investors, that it has shaken confidence in the country's entire regulatory system."
What can the SEC change?
Sound suggestions for improving the SEC have been made, both by outsiders and even by the SEC itself. The SEC has issued a paper outlining the moves it is making in response to the Inspector General's report regarding Stanford.
Among the steps being considered or already being put in place are "Establishing escalation procedures and revamping the process for handling tips, complaints and referrals ... Changing performance metrics so that quantity does not trump quality ... Streamlining the approval procedures ... considering potential, and potentially growing, investor harm ... Establishing and consistently applying factors for referring matters to others agencies."
But all of these ideas rely on people to execute them. And that is where I believe the SEC is still falling short. I have written here and here that one shrewd move would be to mix up the staff, by hiring financial journalists instead of more attorneys. Lawyers are trained to think the same way, and many of whom, it is often said and has been repeatedly shown, are merely using the SEC as a launching pad for their careers, oftentimes with the very financial entities they were charged with investigating. Perhaps pair financial journalists with lawyers and outside experts if the information they find is particularly nettlesome. And publish their results.
Other ideas: The SEC shouldn't just file small cases that are easy to win. It should search court records and the financial press to see if the people being accused of fraud have done it before, elsewhere. Better computer systems could go a long way in tracking this kind of data. It should develop sources who know things, just as journalists already do, and use tried and true project management techniques from the private sector to track and validate cases. Most importantly, it should continue on the heartening path that investigations into Goldman Sachs and now ICP seem to show the commission traveling on. That is, the SEC, if it is to exist, should be bold.
-- Randy Shain is executive vice president of First Advantage Litigation Consulting/BackTrack Reports and author of the book Hedge Fund Due Diligence: Professional Tools to Investigate Hedge Fund Managers. Opinions expressed are his own and not those of his employer.