Take a regulatory agency already under fire for its performance over the past few years, a hostile Congress whose leadership craves ammunition it can use in its ongoing battle over that agency's budget, and a vocal minority in the media that vehemently believes the agency's failings are not due to mistakes or even incompetence, but to “regulatory capture” or outright corruption on the part of its leadership.

To this toxic mix, throw in a whistleblower's allegations that the agency is engaged in a practice that can be, at a surface level, described as destroying evidence. Now you have the blazing bonfire facing the Securities and Exchange Commission as this summer comes to an end.

For those of you at the beach for the last two weeks of August, here is some quick background on what occurred:

On Aug. 17, Matt Taibbi, a columnist for Rolling Stone, broke a story under the headline, “Is the SEC Covering Up Wall Street Crimes?” Taibbi reported that an SEC attorney named Darcy Flynn had contacted Congress with allegations that since 1993, the agency had been following a policy of discarding its documents and files from preliminary investigations called “Matters Under Inquiry” (MUIs) if the MUI was closed out and not pursued by the SEC as a formal investigation.

Indeed, the SEC's document policy, as reportedly set forth on its internal Website, expressly instructed its staff: “After you have closed an MUI that has not become an investigation, you should dispose of any documents obtained in connection with the MUI.” This policy may have resulted in the SEC discarding case files for at least 9,000 MUIs through the years, Flynn estimates.

Sen. Charles Grassley, (R-Iowa) immediately fired off a letter to SEC Chairman Mary Schapiro demanding more information about what the SEC had done with the MUI records, and why. He requested that by Aug. 31 the SEC provide a full accounting of its document destruction policies, and whether its policies were consistent with the laws governing record retention. He also asked the SEC to state specifically whether (and why) it had destroyed documents from MUIs, and to address whether it was concerned that destroying MUI files might harm future investigations.

In his letter, Grassley made the valid points that even if the agency had deemed an MUI not worthy of pursuing, discarding the file from that matter “would appear to greatly handicap the SEC's ability to create patterns in complex cases and calls into question the SEC's ability to properly retain and catalog documents.” He also added that “these records may contain critical information that could be extremely useful in piecing together complex cases, even if not immediately pursued.” To date, the SEC has not yet responded directly to Grassley, but an SEC spokesperson did state that “[t]here's no requirement that every document that comes into an agency's possession in the course of its work must be retained. The agency retains records of its inquiries, which are available to investigative staff throughout the agency.” The SEC's inspector general is now looking into the matter and is expected to issue a report by the end of September.

“The get-a-life adage should attach to the agency's critics who are convincingly clueless in their understanding of the agency's investigative process and revitalized enforcement program.”

—Jacob Frenkel,

Former Senior Counsel, Enforcement Division

Securities and Exchange Commission

Although Grassley has had his share of bitter squabbles with the SEC, he seems at least to be engaged in the right discussion here. Why did the SEC establish a policy of discarding closed–out MUI files rather than retaining them somewhere on the off chance that they may someday prove useful in a future investigation? And did the SEC even have the legal authority to discard these files? Others such as Taibbi, however, look at the same facts and head down a more cynical path.

Taibbi, for instance, contends in the article that to some meaningful extent, the SEC MUIs at issue involve “Wall Street criminals.” He further argues that these MUIs are closed not because they deserve to be, but because—due to regulatory capture and a revolving door between the SEC and the private sector—the Commission has become a “police force that has effectively been conquered by the financial criminals it is charged with investigating.”

Taibbi concludes that the reason the SEC maintained this policy of discarding closed MUIs is “something far more than an administrative accident or bureaucratic f--- up.” Rather, he says, the SEC is “whitewashing the files of some of the nation's worst financial criminals” and “weighted down a huge sack of Wall Street's dirty laundry and dumped it in a lake, never to be seen again.”

Others such as Bloomberg Columnist William Cohan have since piled on to say that the SEC's policy of destroying closed MUI files proves that the entire agency is unsalvageable and should be “terminated” and replaced with “a new regulatory watchdog for Wall Street free of obvious conflicts of interest.”

Is Taibbi's view of the world possible? Sure—anything is possible. But given my own experience at the SEC in the mid-1990s, the experience of my friends and former colleagues at the agency, and the facts as we know them so far, I believe that the odds of this being the case are astronomically low. Jacob Frenkel, a former senior counsel in the Enforcement Division, flatly states: “The conspiracy allegations are absurd.” Next, he says, “they'll be spouting that the SEC also failed to, but should have, predicted the Mineral, Virginia, earthquake because disclosure of mineral rights falls within the SEC's jurisdiction … There is not now nor has there ever been an effort at the SEC to whitewash violations on Wall Street.”

Russ Ryan, a 10-year veteran in the SEC's Enforcement Division and now a partner at King & Spalding, agrees with Frenkel: “Any suggestion that SEC staffers think their path to success is going soft on Wall Street banks is exactly the inverse of reality.” According to Ryan, “every SEC staffer” knows that the best and fastest way to get recognized, rewarded, and promoted within the agency is to pursue the rich and powerful aggressively and to bring them down.

As to whether the SEC implemented a policy to discard closed MUI files to help whitewash Wall Street's dirty laundry, here are some facts to consider:

MUIs are preliminary investigations—the earliest possible stage of an SEC inquiry. MUIs can be opened by low-level SEC staff on even the slightest suspicion, such as something noted by a staff attorney in a newspaper article read on the subway that morning, or news that a company's auditor has resigned.

Ryan estimates that while some small percentage of MUIs inevitably relate to Wall Street firms, that percentage is probably less than 10 percent.

The SEC requires that the staff make a decision on whether to pursue MUIs further as a formal investigation within 60 days of an MUI being opened. Ryan says that the overwhelming majority of closed MUIs are brought to a prompt close for the simple reason that the initial inquiry results in no evidence that would justify pursuing it further. Ryan says a few exceptions exist, such as cases where the SEC concludes that another entity (FINRA, for example) is adequately handling the matter or that the agency's resources are better focused on more important cases. “But in almost 20 years inside and outside the agency, I never heard of any promising MUI that ever got closed because supervisors were afraid to take on the rich and powerful,” Ryan says.

According to Frenkel, the percentage of cases where the staff believes the evidence justifies expanding an MUI into a formal investigation, but then has its request “thwarted by senior officials” (one alleged example of this is discussed in the Rolling Stone article), is negligible.

So why has the SEC followed a policy of discarding closed MUI files for many years—possibly even in violation of federal law? Perhaps it will turn out that privacy concerns prompted the policy, and that the agency concluded at some point that keeping files on people and entities that turned out to be dry holes, which then become fodder for Freedom of Information Act requests, isn't a wise idea. Or perhaps, as Peter Henning suggested in a recent DealBook column, the SEC engaged in “corner cutting to avoid cumbersome federal regulations” on document disposal and retention.

The SEC inspector general will presumably provide a definitive answer to this question in the near future. Until then, Frenkel says, “the get-a-life adage should attach to the agency's critics who are convincingly clueless in their understanding of the agency's investigative process and revitalized enforcement program.”